Dollar-cost averaging vs lump sum investing
moneyrelations :: Feb.06.2008
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There’s a provocative article by Walter Updegrave on CNNMoney regarding dollar cost averaging. I liked it because right or wrong, it challenges conventional wisdom.
The title of the article is Don’t buy into dollar-cost averaging.
First, let’s define the term. From Wikipedia:
Dollar cost averaging is an investing technique intended to reduce exposure to risk associated with making a single large purchase. The idea is simple: spend a fixed dollar amount at regular intervals (e.g., monthly) on a particular investment or portfolio/part of a portfolio, regardless of the share price. In this way, more shares are purchased when prices are low and fewer shares are bought when prices are high.
Mr Updegrave is arguing that given a large amount of money, investors should invest it in a lump sum rather than dollar-cost average. So why does he take this position?
Most investors have risk profiles and asset allocation plans already drawn up (or they should) according to their investing time horizon. He takes a scenario of $60k in cash ready to invest. His asset allocation plan states that he should invest 60% in stock funds and 40% in bonds funds. For our purposes, there are no transaction costs for buying these funds. He divvies his $60k into 12 equal installments of $5k each month for the year. According to the dollar-cost averaging plan, he should be investing $3k (5k * 60%) in stocks and $2k (5k * 40%) in bonds. However, this would not be truly indicative of his risk profile. The 60-40 split is only on his installments of five thousand dollars and does not take into account the money he still has to invest. Therefore, he’s under-invested according to his asset allocation.
Mr Updegrave makes a good point. Why have an allocation plan if you don’t follow it?
The come back, of course, is what happens if you purchase the funds at their peak and the market drops afterwards? Wouldn’t it be safer to DCA as it forces you to buy more units when the prices are low but reigns you in when the prices are high?
And again, the counter argument to that is that the investor’s time horizon is already accounted for in the asset allocation mix and is truly matched in a lump sum strategy. Therefore, to look at the positive, the money will be working from the beginning should the price rise.
I can understand both arguments but despite what people say about not being able to time the market, I think if you are interested in actively managing your portfolio, the lump sum strategy is not a bad way to go - at least there’s a general idea that a sector might be cheap. And if you’re a nervous investor, or not remotely interested in following the markets, playing it ultra conservative with dollar-cost averaging might be a viable option as well.
Definitions, Investing, Investing myths ::
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I’ve read similar articles (in Money Magazine, for instance) that indicate lump sum investing beats DCA. The reason I’ve always heard is that stocks go up more years than they go down.
If you have $5000 in cash to invest in an IRA for instance, go ahead and put it in your IRA in January. Odds are it’ll be worth more at the end of the year than if you made 12 monthly investments. It gives all your money all 12 months to compound. Sure, the market may dip in February (like now), but odds are you’ll still be better off next year by dumping it all in at once.
Of course if you do this every January then it’s technically dollar cost averaging, just on an annual basis instead of monthly.
Hi Meg,
Thanks for the comment.
I wouldn’t have problems doing a lump sum of 5k - in fact, have done so… and higher on my infamous penny stock buys to avoid commissions. But in this case, we’re talking about mutual funds so no transaction cost involved.
Regardless, 60k is a big hunk of change to invest at once. I’d only do it if I was really into watching the market to time it… It might not make much of a difference to DCA quarterly, or even monthly but I’d be psychologically more comfortable with that.
doesn’t dollar cost averaging assume a mutual fund? eg., I would not buy only $500 of any given stock (waste the commission) so how else would I ‘average’ it out each month?
Hi Nancy,
For sure, commissions are a factor to consider to calculate when investing. The author of the article does think that DCA is a good idea for small amounts of money like $500. He used MFs but I don’t think the strategy is implicit that it’s only for MFs though. There is a “rule” that the commissions should not be more than %1 of the investment. So if you wish to purchase $500 of stocks, commissions should not exceed $5. I’m not an expert in discount brokerage fees but I pay $7 per trade with a big bank so $5 should be doable with some brokerage shopping.