Q: I inherited some money recently but with the market at all-time highs, I ’m worried I will invest and see it drop immediately. A broker friend says I should dollar cost average. Is that a good idea?
A.: Assuming you are going to be broadly diversified rather than buying just a few stocks, dollar-cost averaging is not a bad idea, but it isn’t great either. It can be somewhat useful as a psychological crutch but historically it has more often cost people money rather than preserved their assets.
Dollar-cost averaging (DCA) is buying into a holding with a fixed dollar amount at fixed time intervals. For example, if you had $120,000 to invest in “XYZ Diversified Fund”, you might buy $10,000 every month for a year. If XYZ’s price drops, only the $10,000 purchases you made prior to that point would be affected and you would actually buy more shares at the lower price with the next purchase. Sounds good, right?
Well, the reason it hasn’t worked out so well for most people is that markets go up more often than they drop, and bull markets tend to rise more than bear markets fall. Historically, about 70% of the time, just investing a lump sum at one time yielded a better result than dollar-cost averaging over a 12-month period.
For DCA to pay off, the market must decline, by enough and for long enough, to get a lower average per share price than a lump sum initial purchase would produce. The longer the time frame, the better the odds the market will not do this and DCA will produce an inferior result.
That’s the math and history. As is the case here though, DCA is often suggested to help nervous investors take action. There is some value on this point, but you must keep in mind a couple of important issues.
First, DCA only works if the market drops and then you actually buy during the downturn. DCA looks good on paper, but when markets drop, the fervor over how bad it is and how likely it is things will get worse does not induce calm. For nervous investors, drops don’t trigger the urge to buy, they stoke the fear. In real time, fear can cause a pause in the buying and undermine the strategy under the exact circumstances within which DCA works best.
Second, DCA just delays the state about which you are fearful. Once the DCA period is over, all the money is subject to market risks, just as it would be if you were to invest as a lump sum.
Investing is supposed to be a long-term activity. You will be a better investor by learning to be resilient rather than fretting about how to be nimble.
Be honest with yourself about your temperament. Dollar-cost averaging might reduce the regret you would feel if the market took a tumble soon after you got started, but it does nothing to prepare you for the many drops you will experience over the long term.
Whether you buy in over time or not, I’d recommend learning what to expect from financial markets and the investor behavior that goes along with its gyrations. Bad markets should be expected and planned for, not feared.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.