I read a really interesting post over at Darwin’s Money today about dollar cost averaging. Darwin presents some really compelling data about why investing a lump sum is better than spreading your investment across several years, or dollar cost averaging.
What is dollar cost averaging? It’s the technique of buying a fixed dollar amount of a particular investment on a regular schedule, be it weekly, monthly, yearly, or anything in between. The idea behind dollar cost averaging is that it lessens the risk that you’ll invest a lot of money at the wrong time. One of the basic tenets of investing is not to try and time the market, you will probably fail. So dollar cost averaging seems like a great way to avoid timing the market.
What’s wrong with dollar cost averaging? If you look at a very short, specific period of time, say the week before the market crashes, dollar cost averaging may seem like a much better idea than lump sum investing. After all, you’d be pretty angry if you had invested $100,000 and then a week later the stock market imploded. But over time, the market tends to go up, so if you look at the big picture, you want to have as much money invested as early as possible to benefit from the increases over time. Darwin pulled some data together showing the difference between an investment of $120,000 over the past 10 years. In his dollar cost averaging scenario, the money was invested in $1000 chunks each month for 10 years. In his lump sum scenario, all $120,000 was invested on day 1, 10 years ago. The results are staggering. In the dollar cost averaging scenario, the investment grew to $194,000. But in the lump sum scenario, the investment grew to $339,000! Though there may be periods of decline, on average the stock market increases, so having all of the money invested from the start allows you to take advantage of all those increases.
This is all great information, but it’s not the reason I’m not dollar cost averaging. In fact, if you look at my investment activity, you’d probably consider what I’m doing dollar cost averaging. I have automatic transfers set up to invest a fixed amount money into my 401(k), a fixed amount into my Roth IRA, and a fixed amount into a mutual fund each month. Sure sounds like dollar cost averaging, doesn’t it? But there’s one important distinction: I’m not doing it as a strategy to mitigate risk. I’d like to propose a new term: incremental investing. In practice, it’s the same as dollar cost averaging, but the strategy component is not there. I’m not consciously investing a fixed amount each month because I believe it’s less risky than lump sum investments, I’m doing it because that’s how money becomes available to invest. It peeves me a little when others tout their great dollar cost averaging strategy when really they’re just investing as money becomes available because it’s the only option they have.
I can look at Darwin’s data and say, “great! I’m going to throw all my cash into the stock market now because that would be better than spreading my investments out over time,” but the problem is, I don’t have a ton of cash to throw into the stock market… because I’ve been incrementally investing it over the past couple years as I earned it! Dollar cost averaging can only be applied when you have a large sum of cash on your hands, which doesn’t happen too frequently for most of us. The more likely scenario is that you get paid every other week, or once a month in my case, so dollar cost averaging isn’t even applicable, in my opinion. Your choices are either invest incrementally as the money comes in, or save up a large sum of cash in a savings account and then either make a lump sum investment or dollar cost average. I think we can all agree that it’s better to invest as the money comes in than to wait 10 years until you have $120,000 sitting in the bank that you can invest in one lump sum.
This post went in two directions (I’m sorry!), but to wrap up, here are the main points:
- You probably don’t have a large pile of cash sitting around, but if you do, chances are investing it as one lump sum (or several lump sums into different investments) today is better than spreading out your investments over several years. The only catch is if you happen to do your lump sum investment immediately before the market tanks.
- If you invest part of your paycheck each month in retirement accounts and taxable accounts, I don’t think you should call that dollar cost averaging. You’re not investing fixed amounts because you believe it’s a better strategy than investing a lump sum, you’re doing it because money becomes available in small amounts each month. I think you should call it “incremental investing.”