Millions of people use dollar-cost averaging to ease their way into their portfolio positions. But is dollar-cost averaging a dumb move?
A recent study from VanguardÂ (link opens PDF file) has gotten a lot of attention by suggesting that dollar-cost averaging isn't the optimal way to put a lump sum of money to work. But even though the results of the study show that dollar-cost averaging often leads to worse returns than simply dumping all your cash into the market at the same time, the intangible benefits from using the strategy may well outweigh any lost profits.
Giving up money
The gist of dollar-cost averaging is that by putting a fixed amount of new money to work at regular intervals, you'll benefit from volatility in the market. In particular, when shares of a stock or fund drop temporarily, your fixed dollar amount will buy more shares at exactly the time when the investment presents the best value proposition. On the other hand, when shares are expensive, your fixed investment buys fewer of them. If the price of an investment zigs and zags upward and downward while eventually landing in pretty much the same place it started, then dollar-cost averaging can eke out a positive return even when the stock price reflects flat or even slightly negative performance.
As the study notes, however, the problem with dollar-cost averaging comes when investments tend to move upward over time. By failing to buy at your earliest opportunity, you give up the often higher returns of being fully invested. And with interest rates on cash balances being close to zero at the moment, the opportunity cost of having a considerable chunk of cash on the sidelines is particularly high.
When the Vanguard study looked at historical performance for U.S. asset classes, it found that on average, using dollar-cost averaging to invest a lump sum over 12 months underperformed simply investing it all on Day 1 about two-thirds of the time, regardless of whether the portfolio was stock-heavy, bond-heavy, or relatively balanced. A similar look at the U.K. and Australia over shorter historical periods showed similar results.
When dollar-cost averaging makes the most sense
Predictably, the study has drawn a lot of criticism from financial planners, who argue that other factors come into play and support dollar-cost averaging. For instance, investing everything at the same time runs the very real psychological risk of suffering immediate losses after making the initial investment, which can wreak havoc with investors' confidence and lead them to reject sound investing strategies after short-term losses due to bad timing.
But the rest of the study actually quantifies that risk. After 10 years of investing with a $1 million portfolio, on half of all historical occasions, using lump-sum techniques beat using dollar-cost averaging by $55,000 or more. But a quarter of the time, dollar-cost averaging saved $43,000 or more -- and on the true outliers, the strategy saved more than $200,000 5% of the time. That risk reduction is meaningful, even if it came at the cost of greater returns much of the time.
What those results suggest is that using dollar-cost averaging for your riskiest plays may make the most sense. For instance, high-beta materials stocks Freeport-McMoRan Copper & Gold (NYSE:FCX), ArcelorMittal (NYSE:MT), and Teck Resources (NYSE:TECK) have proven extremely vulnerable to worsening conditions in the global economy, with shares moving abruptly when economic news provides more information about the future. Using dollar-cost averaging for those stocks could help you avoid calamitous downward movements while letting you take advantage of potential gains.
Conversely, low-volatility plays probably don't need the extra protection of dollar-cost averaging. If low-beta stocks Abbott Labs (NYSE:ABT) and Altria (NYSE:MO) continue their past ways, then you'll likely end up better off simply taking the plunge.
Of course, for many of us, the luxury of lump-sum investing isn't available because we don't have lump sums to invest. If you're regularly investing out of your paycheck, don't be afraid to use dollar-cost averaging. It will serve you well, and more important, it's the best way to keep the discipline of putting money toward your savings regularly.
Fool contributor Dan Caplinger has no positions in the stocks mentioned above. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold and ArcelorMittal. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.