Many of us are familiar with the concept of dollar cost averaging (DCA). While specifics may vary, it involves investing a fixed dollar amount at regular intervals over a specified period, and is contrasted with lump sum investing (LSI), or investing all at once.
A popular notion has it that DCA is somehow beneficial to investors because it allows them to buy more shares when prices are low and fewer shares when prices are high. Does academic research bear this out? These titles of academic papers are pretty clear about the answer:
A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy1
Nobody Gains from Dollar Cost Averaging: Analytical, Numerical and Empirical Results2
While there may be some emotional appeal to the idea of not committing too much in case the market goes down, it should be intuitive that with a market that goes up over time and offers a premium for being in stocks and bonds, the best chance for success lies with lump sum investing (LSI). In a July 2012 paper (“Dollar cost averaging just means taking risk later”), Vanguard concludes:
“An LSI approach has outperformed a DCA approach approximately two-thirds of the time, even when results are adjusted for the higher volatility of a stock/bond portfolio versus cash investments…the prudent action is investing the lump sum immediately to gain exposure to the markets as soon as possible.”3
That is not to say that LSI outperforms or will outperform over all periods—DCA has done better in market downturns. If a very nervous investor wants to dip a toe rather than dive headfirst into the investment waters, DCA may be appropriate:
“…if the investor is primarily concerned with minimizing downside risk and potential feelings of regret (resulting from lump-sum investing immediately before a market downturn), then DCA may be of use. Of course, any emotionally based concerns should be weighed carefully against both (1) the lower expected long-run returns of cash compared with stocks and bonds, and (2) the fact that delaying investment is itself a form of market-timing, something few investors succeed at.”
Of course, investors who contribute a portion of each paycheck to a savings or retirement account are doing their own form of DCA, and much of the popular writing about DCA is in this regard. But that is different from holding back available cash from going into a target asset allocation.
Transaction costs involved with DCA steps are another consideration. In transaction-based accounts, the more DCA steps, the higher the cost to the investor (brokers must love DCA!).
So what does this mean for investors? Bottom line is that likely for the vast majority, LSI into an asset allocation that appropriately reflects their objectives and risk tolerance is the way to go. If the investor is very resistant to using LSI in these situations, it might be wise to take another look at whether the allocation is indeed appropriate given this reluctance.
One potential use for DCA is for investors receiving a big lump sum, relative to net worth, e.g., selling a business. Someone who is new to being a big investor may panic if there is an initial market downturn that causes large losses in dollar terms. DCA may help the transition and support ongoing investment discipline for these investors.