Easing into risk: Dollar cost averaging

Dollar cost averaging (DCA) is the practice of investing a regular amount
of money at set time intervals, such as monthly or quarterly, into volatile
investments, such as stocks and stock mutual funds. If you’ve ever deducted
money from a paycheck and pumped it into a retirement savings plan investment account that holds stocks and bonds, you’ve done DCA.
Most people invest a portion of their employment compensation as they earn
it, but if you have extra cash sitting around, you can choose to invest that
money in one fell swoop or to invest it gradually via DCA. The biggest appeal
of gradually feeding money into the market via DCA is that you don’t dump all
your money into a potentially overheated investment just before a major drop.
Thus, DCA helps shy investors psychologically ease into riskier investments.
DCA is made to order for skittish investors with large lump sums of money sitting in safe investments like CDs or savings accounts. For example, using DCA,
an investor with $100,000 to invest in stock funds can feed her money into
investments gradually — say, at the rate of $12,500 or so quarterly over two
years — instead of investing her entire $100,000 in stocks at once and possibly
buying all of her shares at a market peak. Most large investment companies,
especially mutual funds, allow investors to establish automatic investment
plans so the DCA occurs without an investor’s ongoing involvement.
Of course, like any risk-reducing investment strategy, DCA has drawbacks.
If growth investments appreciate (as they’re supposed to), a DCA investor
misses out on earning higher returns on his money awaiting investment.
Finance professors Richard E. Williams and Peter W. Bacon found that
approximately two-thirds of the time, a lump-sum stock market investor
earned higher first-year returns than an investor who fed the money in
monthly over the first year. (They studied data from the U.S. market over the
past seven decades.)
However, knowing that you’ll probably be ahead most of the time if you
dump a lump sum into the stock market is little solace if you happen to invest
just before a major plunge in prices. In the fall of 1987, the U.S. stock market,
as measured by the Dow Jones Industrial Average, plummeted 36 percent,
and from late 2007 to early 2009, the market shed 55 percent of its value.
So investors who fear that stocks are due for such a major correction should
practice DCA, right? Well, not so fast. Apprehensive investors who shun
lump-sum investments and use DCA are more likely to stop the DCA investment process if prices plunge, thereby defeating the benefit of doing DCA
during a declining market.
So what’s an investor with a lump sum of money to do?
✓ First, weigh the significance of the lump sum to you. Although $100,000
is a big chunk of most people’s net worth, it’s only 10 percent if your
net worth is $1,000,000. It’s not worth a millionaire’s time to use DCA
for $100,000. If the cash that you have to invest is less than a quarter of
your net worth, you may not want to bother with DCA.
✓ Second, consider how aggressively you invest (or invested) your
money. For example, if you aggressively invested your money through
an employer’s retirement plan that you roll over, don’t waste your time
on DCA.
DCA makes sense for investors with a large chunk of their net worth in cash
who want to minimize the risk of transferring that cash to riskier investments, such as stocks. If you fancy yourself a market prognosticator, you can
also assess the current valuation of stocks. Thinking that stocks are pricey
(and thus riper for a fall) increases the appeal of DCA.
If you use DCA too quickly, you may not give the market sufficient time for a
correction to unfold, during and after which some of the DCA purchases may
take place. If you practice DCA over too long of a period of time, you may miss
a major upswing in stock prices. I suggest using DCA over one to two years to
strike a balance.
As for the times of the year that you should use DCA, mutual fund investors
should use DCA early in each calendar quarter because mutual funds that
make taxable distributions tend to do so late in the quarter.
Your money that awaits investment in DCA should have a suitable parking
place. Select a high-yielding money market fund that’s appropriate for your
tax situation.
One last critical point: When you use DCA, establish an automatic investment
plan so you’re less likely to chicken out. And for the more courageous, you may
want to try an alternative strategy to DCA — value averaging, which allows you
to invest more if prices are falling and invest less if prices are rising.
Suppose, for example, that you want to value average $500 per quarter into
an aggressive stock mutual fund. After your first quarterly $500 investment,
the fund drops 10 percent, reducing your account balance to $450. Value
averaging suggests that you invest $500 the next quarter plus another $50 to
make up the shortfall. (Conversely, if the fund value had increased to $550
after your first investment, you would invest only $450 in the second round.)
Increasing the amount that you invest requires confidence when prices fall,
but doing so magnifies your returns when prices ultimately turn around.