Recently in a Money magazine article on dollar cost investing they made some very compelling arguments for not taking this particular approach. And to back up this claim is none other than the investment giant Vanguard. This approach goes against almost everything that I have read or been taught over the years, but after reading the article, I must admit it does make some sense. But first, we will examine what dollar cost investing is and how it works. Then we will look at what Vanguard studied on the subject and concluded. And when it is all said and done you may be like me and have a change of heart.
Say you come into a large sum of money and would like to invest it. Most people are fearful of investing large sums of money all at once because the markets could crash the next day. After all, the markets are unpredictable in nature. So what people do to dollar cost invest is take a portion of the money and invest it on a regular interval. Be that monthly or quarterly but the key here is to buy on the schedule you created. And the theory behind it is you will buy at times when the markets are strong thereby purchasing less of a security and when times are weaker and the markets are down buying more of the security. And over time the price will average out to be better than had you taken the risk and bought at the wrong time, say when the markets are in an eight-year bear market as we are in today.
So with that thinking, it makes sense to invest gradually over a set period, say a year or two. Even Warren Buffett tells people that they should invest in a low-cost indexed fund over a period to maximize their investing power. But is that indeed the wisest way to invest? That is what Vanguard set out to find out, and they did just that by looking back since 1926. And since 1926 we have had all kinds of markets and markets of different lengths of time. So if you can spread the risk and diversify your purchase prices why would you instead make a lump sum purchase?
Well, first the markets over the years tend to go up more than they go down making it likely that you will purchase at one price but over time that price will increase. Meaning spreading your purchases over a period of time might now mean as much as we thought. I have been investing since the late 1990’s, and there have been two times in which I would have made lump sum purchases no matter what And that was the dot.com bubble burst of 2000 but then not so much as the Great Recession of 2007 through 2009. In early 2009 it would have been an excellent time to purchase just about any stock. But hindsight is always 20/20, and in 2009 no one other than maybe Warren Buffett and some hedge funds were buying anything. Most people were more worried about how they would pay their bills and simply survive. While Warren Buffett may be proven wrong in dollar cost investing he is correct when he states the time to be fearful is when others are greedy, and it is time for you to be greedy when others are fearful.
From 1926 through the end of 2015 there are 1,069 overlapping twelve month periods in the markets. And yes, there was every conceivable market happening in that period as well. Vanguard found that in two-thirds of the time the people who invested in a lump sum did 2.4% better over those twelve month periods. That means dollar cost averaging did better only a third of the time. Not a ringing endorsement for that approach but at least the gains were not larger. But if you were in your 20’s or 30’s when you made the investment 2.4% over 30 or 40 years compounded is some serious money you are leaving on the table. People fret about 0.5% over 30 years so you can imagine what 2.4% would do to your investments. So that is reason one why lump sum investing is better than dollar cost averaging. And now on to reason two which is more complex in nature.
If you follow an investment plan, then you have your ideal mixture of your asset allocation that you have decided to follow. Say you want to be 75% stocks and 25% bonds and you have $120,000 to invest over twelve months to dollar cost average. We will start in January with our first purchase of $7,500 in stocks, $2,500 in bonds and do that for the next twelve months. Here is the problem. At the end of your first month, you have $7,500 in stocks, $2,500 in bonds and $110,000 in cash. Remember your risk tolerance has determined your asset allocation at 75% stocks and 25% bonds with no cash. At the end of January, your asset allocation is about 6.3% stocks, 2.08% bonds, and 91.7% cash. That is nowhere near your desired asset allocation. This means your returns will be much lower than what you would have expected had you invested all at once. Stocks earn the most in returns as they are the riskier of the three assets followed by bonds and finally cash. By dollar cost averaging you are not following your investment plan and asset allocation allotments.
If you still cannot go ahead and buy all at once there is nothing wrong with that but it is better to dollar cost average no more than twelve months in duration, or you run the risk of being out of balance too long with your desired asset allocation. If you can, it is best to do this over three or six months at the longest. Even if you had bought all of your stocks in 2007, you would have regained all of your losses by 2012 and would have seen significant growth even since then. Will the markets go down again? Certainly, they will but as time has proven to us, they will indeed go back up and see new heights that no one could have predicted. Look at where we were ten years ago and look at where we are now.
If you have any questions or need any additional help, feel free to contact me directly or leave a message here on the site.
