Are you a dive straight into the pool kind of person? Or perhaps you enter one step at a time, pausing to let your body adjust to the water with each step you take. Do you dip a toe in to check the temperature before slowly creeping in? People enter the water a little differently, just like people enter the markets differently. Today, I want to talk about one such approach called “dollar cost averaging.”
We recently received some questions regarding our thoughts on dollar cost averaging. Is it good? Is it bad? Do you recommend it? Our definitive answer: It depends.
First, a little background. Dollar cost averaging is the practice of systematically investing money you already have. It is not saving a certain amount from your paycheck every month. This is an important distinction — with dollar cost averaging you make the conscious choice to keep money in cash or something similar. We typically see this from people who recently sold a business, received an inheritance, or had some other windfall.
Finance Professors vs. Real People
From a finance professor’s perspective, dollar cost averaging is crazy. Presumably, your investment portfolio has a higher expected return than a money market fund (if it doesn’t, you may want to reconsider your asset allocation). To maximize wealth, all that money should be invested as quickly as possible. The problem is that numbers aren’t the only factors in play, and dollar cost averaging considers other elements like risk tolerance.
Let’s say you develop an overall investment plan with an advisor that is put into action. You begin by investing one-eighth of your money. On the first day, the market drops five percent. Are you going to want to pull everything back to cash? If you’re comfortable letting it ride, then you should probably just go ahead and invest the rest of the money. If you’re wary of the ups and downs of the market, or you fear the “And…it’s gone” scenario, then you might want to think about dollar cost averaging.
A good way to think about this is through the lens of acts of commission vs omission. Most people prefer doing nothing and missing a big gain to doing something and taking a big loss. That’s standard loss aversion. Dollar cost averaging allows you to slowly get more comfortable with the market. If you plan to invest a quarter of your money every three months and you see bad returns on the first day, have no fear — most of the money is safely in your bank account. On the other hand, if the returns are good, you enjoy a little boost.
As you invest more over time, hopefully you’ll become more comfortable with being in the market and you’ll be able to stick to your plan. If your comfort level isn’t quite there at the end of the process, you should probably reconsider your portfolio and take less risk.
Don’t drag it out
Don’t drag this process out for too long, though. Dollar cost averaging can help you get more comfortable with the market, but you need to dive in eventually. The longer your money is invested, the more time it has to work for you. There are no hard and fast rules, but it shouldn’t take more than a year or two to get fully invested. If you’re uncomfortable with that time frame, you probably need to adjust your asset allocation and take less risk.
This is not market timing
It’s important to note that dollar cost averaging is not market timing (trying to predict the right time to invest). No one knows what the markets are going to do on a day-to-day, month-to-month, or even year-to-year basis. On the contrary, when you try dollar cost averaging shouldn’t matter. It is merely a practice intended to help new investors find their comfort level in the market, regardless of performance. All we can do is give you the best possible chance to have a successful retirement and not have to worry about your investments. And to the extent that dollar cost averaging helps you stay the course, it can help you get there.
Dollar cost averaging is about entering the markets at your own pace, whether by dipping a toe in to check the climate or taking it one step at a time. What matters most is that you get in the water — how you get in is up to you.
McLean Asset Management Corporation (MAMC) is a SEC registered investment adviser. The content of this publication reflects the views of McLean Asset Management Corporation (MAMC) and sources deemed by MAMC to be reliable. There are many different interpretations of investment statistics and many different ideas about how to best use them. Past performance is not indicative of future performance. The information provided is for educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy or sell securities. There are no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information on this presentation. Indexes are not available for direct investment. All investments involve risk.
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