Does Dollar-Cost Averaging Make Sense?
As with most financial questions, there are two answers to consider.
Suppose you have a sum of money to invest. Should you put it to work all at once or should you invest it incrementally?
According to Morningstar data, the U.S. stock market has delivered positive returns in approximately three-quarters of annual periods historically. So the logical conclusion for an investor with surplus cash would be to invest it right away. After all, if the future looks like the past, you’ll have a 70%+ chance of making money over the coming year.
That’s the mathematical answer, but I see at least three reasons why you might still consider an incremental approach:
1. Regardless of what the math says about your ability to afford losses, no one likes to see declines. If you invest a substantial sum on Monday, and the market declines sharply on Tuesday, you will be unhappy. And even if the market eventually rebounds—as it always has—research by Daniel Kahneman tells us that it’s important to manage losses.
Prospect Theory was developed in 1979 by Kahneman and his colleague Amos Tversky. It’s famous because it took down one of the longstanding and fundamental pillars of economics—the concept that individuals will always seek to “maximize utility.” Contrary to the economics textbook, Kahneman and Tversky found that people look at potential losses and potential gains differently. For example, people dislike a $1 loss more than they enjoy a $1 gain. In fact, they found that it takes a gain of about $2 to offset a loss of just $1. In other words, people really dislike losses, even if the data tell us that they’re likely to be temporary. That is a key reason to consider investing incrementally.
2. There are periods when the market is inexpensive and periods when it is richly valued. If it’s near a high point, as it is today, that would be another argument for taking things slow.
3. A dollar-cost averaging program gives you the flexibility to accelerate your investments if the market declines.
Recognizing that there are valid arguments on both sides of this debate, I normally recommend a 12-month schedule for sums of cash that exceed 5% of your net worth.