Math vs. Psychology: The Case for Dollar-Cost Averaging

Over the years, the personal finance community has come up with certain ideas that have been adopted by many due to their apparent utility and sensibility. One such concept that has taken hold and become an almost universal belief is dollar-cost averaging, by which small investments are made in a mutual fund on a regular basis, usually biweekly or monthly. This was considered a safer alternative to lump sum investing, where everything is thrown into the market at once come hell or high water.

However, like Galileo attacking the pope with his idea of a heliocentric solar system, a few heretics began to question this accepted dogma. Oddly enough, one of the first salvos came from Vanguard, long regarded as a champion of low-cost index investing for the individual investor. Their army of researchers found that, when it comes to your final account balance, lump sum investing beats dollar-cost averaging two-thirds of the time.

The Numbers vs. Your Emotions

Like many rigorous academic studies, Vanguard’s report used sophisticated analysis to prove a relatively obvious conclusion. Because stocks and bonds offer a higher expected return than cash in the long run — that’s the whole reason you invest in them, after all — it seems to follow that getting as much of your money in the market as soon as possible (i.e. lump sum investing) would be the profit-maximizing strategy.

So, should we just abandon the long-held wisdom of dollar-cost averaging? The answer, as you might expect, is not so simple. Investing is all about balancing tradeoffs, and the decision between dollar-cost averaging and lump sum investing is no different. Although lump sum investing gives you the higher expected return, it also exposes you to more downside risk if the market tanks soon after your “profit-maximizing” investment is made.

When the market falls, dollar-cost averaging gives you the opportunity to buy more shares at bargain-basement prices, thereby reducing both your cost basis and the extent of your losses. Given our inherent desire to avoid the pain of investment losses, sacrificing a little return in order to gain some peace of mind could very well be a worthwhile exchange, especially if it gives you more confidence to stick with a long-term, buy-and-hold strategy during times of market turbulence.

Keep the Big Picture in Mind

Of course, it is important to note that, in terms of your final portfolio value, the differences between the two strategies are actually quite small. Over a ten-year time period, the Vanguard study found that those who implemented a lump sum strategy with a diversified portfolio would have had a final account balance that was almost 2% more than if they had spread out that investment over the course of a year.

Relative to all the other things that can affect the value of your portfolio, this is little more than a rounding error. In the grand scheme of things, such a difference is mainly of interest only among academics and those investors who also delay paying their credit card bills until the due date at 11:59 p.m so that they can earn an additional three cents of interest on the balance.

Avoid Temptation

If the decision truly matters at all, it is because of the discipline that dollar-cost averaging can impose on you. Even if you have all the money you need to invest in a lump sum manner, the point is moot if you never follow through with it. Like hands, idle money is the devil’s playground. You should never overestimate you ability to resist temptation. Although investing for the future is nice, a new car and a big screen television can seem even nicer in the moment. Retirement pays off tomorrow, but spending is fun today!

When you go on a diet, you don’t start by leaving a chocolate cake on your counter in order to teach yourself the ability to resist delicious foods. Instead, you get rid of it, putting it out of sight and out of mind. Likewise, by putting your investment program on autopilot through dollar-cost averaging — either by having the money taken out of your bank account or (even better) your paycheck — you eliminate any temptation to spend it because you never actually see it.

Even if dollar-cost averaging may cause you to leave a little profit on the table, it is the strategy that is best suited to counteract all of our irrational foibles while simultaneously satisfying our innate desire to be lazy. It is a simple, practical, and intelligent way to fund your retirement accounts over a long period of time. In other words, dollar-cost averaging is like Ron Popeil’s Showtime Rotisserie: you can just “set it and forget it.”

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