Does dollar-cost averaging always work?
Popular wisdom suggests that regularly investing month after month is the best way to make money. But is it always?
Dollar-cost averaging - investing a fixed dollar amount monthly to take advantage of market fluctuations - has long been a tried-and-true method of introducing wary investors to the stock market and the concept of forced savings.
DCA is often marketed by investment firms as a great way to maximize your savings dollars while reducing risk. But in actuality, it's not always the best solution.
Holding, on average, half a portfolio in cash through the year is clearly a more conservative route towards buying a higher-risk asset. And, at first glance, it's a rational approach for those who believe that the stock market is a good long-run investment but can't reliably predict its short- or even medium-term movements.
And it does have its psychological appeal as well: if the market dips, you get to keep smiling because averaging down will save you money; if the market goes up, you'll be happy regardless.
But what about someone with a significant amount of cash -- say from the sale of a business, an inheritance or a bonus -- who's not sure what to do next? Some will want to wait to enter the market until stocks fall to a certain level; others will wait for a market rally, hoping to ride the wave. What would you do?
Realizing that this was a real-world situation for many investors, a pair of researchers at Bernstein Global Wealth Management calculated the results of investing in the Standard & Poor's 500 using both a lump sum and dollar-cost averaging for all the rolling 12-month periods going back to 1926.
The average yearly return for the "lump sum" approach, or investing everything at the beginning of the year, was 12 per cent. That compares with 8 per cent under dollar-cost averaging, Bernstein reports.
They also found that in poor markets averaging resulted in 11.6 per cent more wealth than investing all at once. But in strong markets, it would cost you 13.4 per cent in foregone gains.
In years of market drops, the DCA portfolio was insulated because the portion earmarked for stocks wasn't fully invested and earning a little income to boot; however, when things were cooking, the portfolio couldn't fully participate.
Obviously, delaying your entry into the market is valuable when the market is down, but costly when it's up. Remember though, the market has appreciated roughly twice the amount of time that it has dropped and this pattern, one hopes, is likely to be repeated in the future.
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