Another Look at Dollar Cost Averaging
The question about ‘We’re inheriting money’ or ‘we have a lump sum to invest’ should we invest it all now or ‘dollar cost average’ it?
This is a question that many face over time whether it’s selling a business, downsizing a home, inheriting money, or your DC pension from your old employer just arrived.
Investors are thinking - what if the market goes down the next day? That’s a risk I’m not willing to take! There’s a big piece of nuance when we think about the market falling right after we invest that doesn’t get nearly enough air time which I will address towards the end.
The premise of ‘Dollar Cost Averaging’ is that by trickling in money over time, in a systematic and predetermined way, you will reduce the risk of losing money.
But does it?
Not really.
This is an old rule of thumb practice in the wealth management space which is not only costing savers, and fails to accomplish the job it is setting out to do.
It’s been described as a ‘regret minimization’ approach. It’s half investors not wanting to regret a decision, and half advisors not wanting their clients to regret it.
How it works:
Let’s say you have a lump sum, and you want to dollar cost average into your long-term asset allocation, say on the first day of each month for the next 6 month in equal increments.
This is the ‘averaging in’ piece, where you likely won’t get the highest or the lowest price in any of those points, and by spreading them out, the risk of investing at a high point theoretically falls.
As Vanguard and PWL have pointed out – in reality, this hurts investor results about 2/3rds of the time. So the math isn’t on our side with this. More on the math side of the equation can be found from Ben Felix in this video.
The markets generally go up. Investing everything now is the next best thing to investing yesterday, and this is why the research suggests investing the lump sum now.
So the appeal that’s left is the one in our brains that says ‘the research is great, but I’m different, I am cursed with bad luck’.
So we see dollar cost averaging as a tool to help diffuse our perceived bad luck, and move forward with it.
Here’s the thing… after that 6 months… the money is going to be fully invested, right?
What happens if the market falls at that point?
All dollar cost averaging really did was push back the date when we would feel the pain of being fully invested only for the market to fall.
The whole premise was to avoid this, right?
The only way that investing a lump sum doesn’t make sense is if it wouldn’t have made sense to invest the money to begin with. Like speculating and not investing.
If the risk of the account falling now is too much… it will also be too much in 6 months.
Always make sure you are invested within your risk tolerance and have the ability to absorb any gyrations in the market in the meantime.
If investing it all today seems like too much risk – it probably is and still will be in 6 months anyway.
Remember – your investments and any actions taken should be aligned with your financial plan, and what you have built it to accomplish. Let the context of your plan dictate whether an investment action makes sense, and not our gut.
If your willingness or ability to take risk isn’t aligned with a lump sum investment – it means there are problems in your plan and risk preferences that need to be addressed before making this decision.
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