Dollar Cost Averaging
Above-Average Results Not Guaranteed
Today’s subject deals with dollar cost averaging - buying into something as the price fluctuates over an extended period of time, instead of all at once.
In situations where you can choose to DCA or invest all at once (i.e. after receiving a bonus, selling a business, inheriting a large sum, or liquidating some other asset) is it best to DCA into a new investment?
(In some scenarios - like investing a portion of each paycheck - you have no choice but to DCA over time, this article focuses more on the one-time windfall scenarios mentioned above.)
There’s not a “right” or “wrong” answer, but I’ll admit at one point I thought there was a “best” answer, so I’ll take a few minutes to point out things to think about in each situation that you may not be considering.
If you have a large sum of money to invest, you essentially have two options: invest it all at once, or invest it over a period of time.
If you choose to invest it all at once, you are faced with two more options: invest it “now” or wait for the market to “hopefully” pull back by some percent and invest it all at once then.
One risk to consider that’s introduced by waiting for the market to fall before investing: what if the market goes up X+Y% before it falls by the X% you’re waiting for?
In that case, even though you’d buying at a ‘discount’ from “yesterday’s” price, you’re buying at a premium from the price on the day you made your initial decision.
If conditions are such that the overall movement of the market puts prices below your threshold and also below the price when you made your decision, another risk to consider is: will you actually invest at that point, or will you keep waiting for the price to fall even more?
If you think you’ll keep waiting, this could be another reason to not wait at all - oftentimes people will wait through a market downturn and continue to wait all the way through a market recovery - ending up with cash-in-hand that they’d planned to invest but never did.
If you choose to invest all your money “now”, you’ll get immediate exposure to the market - over longer periods of time, this is generally a good thing; however, it comes with the short term risk of a significant pullback making your investment worth less for some period of time until markets recover.
If you choose to Dollar Cost Average into an investment over some period of time, you essentially reduce your risk at the expense of some of the long-term reward.
If there is an immediate market downturn, you’ll have some of your capital liquid still (and be able to buy the investment at a lower price); however, if there’s not a downturn, you’ll have given up that period of growth while the market rose with your cash on the sidelines.
So, while there’s not a “rule of thumb” to abide by when it comes to Dollar Cost Averaging, generally speaking - if time is on your side and you’re risk-tolerant, the more time you have in the market (i.e. an all-at-once investment) the better served you’ll be; if you’re more risk averse (for example: the lump sum you have to invest is proceeds from the sale of a business and represents your entire retirement) dollar cost averaging will provide a safer entry into the market, at the (potential) expense of a little lost growth as you enter.
Whatever you end up deciding to do, be happy - having a lump sum to invest is a great problem to have.