Saturday, April 19, 2014

Dollar cost averaging or investing a lump sum all at once: which performs better?



What is dollar-cost averaging?

Dollar-cost averaging (DCA) — buying a set dollar amount of a security at regular intervals — can help promote disciplined investing.  It is a form of paying yourself first.  While you’re building your wealth, the rate of saving is generally more important than the rate of return.
By committing yourself to invest a set amount regularly (say, $1,000 once a month), regardless of whether the market is up or down, you end up buying more when the market is down and an investment is cheaper, and less when it’s up and an investment is more expensive.
For Mal Spooner, corporate finance professor at Humber College in Toronto and author of A Maverick Investor’s Guidebook, dollar cost averaging is a hedge against the common tendency among investors to buy high and sell low, robbing themselves of profits. “Everybody wants to invest aggressively when markets are going up,” Spooner says. “DCA forces you to buy when markets are bad as well as good.”

So how does the performance of dollar cost averaging compare to lump-sum investing?  

Vanguard, the U.S. mutual fund company, published a study in July 2012 that highlighted an important flaw in the dollar-cost averaging strategy.
The study sought to answer a simple question: If you inherited $1 million, would you be better off investing it all at once or would your portfolio perform better if you were to invest the funds gradually over time (in other words, if you implemented a dollar-cost averaging strategy)?
Vanguard studied stock and bond returns in the U.S., U.K. and Australia. The research covered multiple stretches of time that featured widely varying market conditions, and investment holding periods ranging from one to 30 years. About two-thirds of the time, investors were better off with a lump-sum approach than they were a dollar-cost averaging strategy.

Does this mean dollar-cost averaging is a mistake?

It probably does, if you come into a large sum of money all at once, and you have a long enough time horizon before you need your money. This argument against dollar-cost averaging isn’t complicated. It merely (and correctly) identifies the likelihood that over time, your money will perform better if it is invested in the markets than it will if it is held in cash (either in a savings account or a low-interest earning cash instrument like a Guaranteed Investment Certificate). If someone hands you $1 million, it’s probably not in your best interest to invest $100,000 into a balanced portfolio and stuff the rest under your mattress to be invested piece by piece.

But for those not lucky enough to inherit a small fortune, dollar-cost averaging still makes sense. It helps make saving easier, and it prevents trying to time the market. Save the same amount every month, and the price of your selected securities will dictate whether you buy a lot (when prices are low) or a little (when prices are high).

Dollar-cost averaging is as much a saving strategy as it is an investment strategy.

For help building an investment plan that is tailored to your personal goals, risk tolerance and time horizon, email Tim Weichel at tim@retireonyourterms.ca or call 416-230-2703 or 705-798-0062

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