All in, or bit by bit?
There’s at least a theoretical mathematical argument that the best way to get into the market—assuming you have a lump of cash sitting in a money market, bank account, or CD—is to go “all in” without waiting.
This is due to several factors. One is the “time value” of money. Another is the fact that the direction of the markets is impossible to predict—but on average, historically, stocks have gone up twice as much as they’ve gone down. Based on that alone, the argument goes, it might mathematically seem better to invest everything at once than to apportion your investment over time. And with interest rates so low, there’s a real cost to having cash sit idle for long periods of time as you invest it bit by bit. There’s also the camp that says, “If investing really is a ‘random walk down Wall Street,’ what difference does it make if you invest all at once or gradually over time?”
Why, then, is dollar-cost averaging (DCA) generally presented as the recommended way for most people to invest? It comes down to human behavior.
DCA forces the discipline to continue to invest in good times and in bad. In a recent Wall Street Journal article, Brett Arends acknowledges that we all know we should “buy low” (and we all recognize that things are pretty low right now), but the fear of additional losses keeps many of us from making the decision to invest now.
Arends maintains that this is why DCA works so well. First, with DCA you aren’t waiting for the market to hit bottom—and trying to time the market is a losing proposition that Arends likens to trying to catch a falling knife. And keeping to the sharp implement theme, DCA helps take the edge off investing in both up and down markets: You won’t catch all of the downs, nor will you capture all of the upside.
Do people use DCA because they’re disciplined investors? Some probably are, but I think there may be a more basic reason: Its appeal is all about risk aversion. Most investors would rather avoid a 10% loss more than they’d like to make a 10% gain.
Quantitatively and mathematically, DCA may not seem like the best deal, but try telling that to investors who went “all in” last fall—or at any one of many other times when the market fell 20 to 40%. In hindsight, DCA would have been a great strategy.
Notes
- All investing is subject to risks.
- Past performance is not a guarantee of future results.
- Dollar-cost averaging does not guarantee that your investments will make a profit, nor does it protect you against losses when stock or bond prices are falling. You should also consider whether you would be willing to continue investing during a long downturn in the market, since dollar-cost averaging involves continuous investment in securities regardless of fluctuating price levels.
- The link to WSJ.com will open a new browser window. Vanguard accepts no responsibility for content appearing on third-party websites.
- We invite your comments on this Vanguard Blog entry. Comments will be monitored and published at Vanguard’s discretion. Comments received prior to July 7, 2009 will not be published.
w.r.t. why we hate to lose more than gain — the math is trivial but I’ve noticed that you Vanguard folks keep making the same mistake (this is the second time I’ve seen this error):
Suppose I have $100,000 and I lose 10% of it. Now I have $90,000. What percentage do I need to gain in order to come back to $100,000? I need to gain $10,000 starting from $90,000 or 11.1%. Now that isn’t so bad. But what about an arbitrary loss p? (p/(1-p))=(1/(1-p)-1) is what I need to gain to get back to my original amount, where p is a percentage.
-20% –> +25% gain needed to return to neutral (see 2nd point below, too)
-25% –> +33%
-30% –> +43%
-50% –> +100%, i.e. you need to double your money
-65% –> +185%, i.e. where we are w.r.t. what happened to us in the stock market this past 2 years. So far we’ve gained what? 30% at the best. We have a long way to go to get back to “neutral”.
Which brings me to a second and third point why the fear going down is much greater than the ecstasy going up. First, because we’re not just losing money going down, we’re losing time and the gains we could have gotten during the slide down. Not only have we gone down hill in the absolute sense we’ve lost two years of potential gains. And this gets worse the longer this goes on. Thirdly, has to do with our age. I’m 60 years old, so 2 years is greater fraction of my remaining life span than it is for a 30 year old (2/(85-60)=8% versus 2/(85-30)=3.6%. Thus the fear of loss increases with…
I think we hate to lose more than gain, as we see life choices constricting with the losses, whereas we see choices opening up with the gains. Interesting comment above and this is a good article. Thanks!
One thing the current market crisis has highlighted is that the biggest market gains always come immediately after a collapse. To tell investors they missed out on a 33% gain since March is ignoring the 55% collapse in stock prices that immediately preceded the recent run-up. In other words – unless you ARE a market timer, the 33% percent increase since March is, while not meaningless, certainly not a great source of joy. The DJIA is still down 4,600 points from its Oct. 2007 high. In fact, studies have shown that if you just manage to avoid the 10 worst market days in the past century, your returns would be fabulous – partly because those big market gains, coming on the heels of a market collapse, are misleading because they are not an actual gain – just recouping some of what we lost. And, as the first poster noted, a 33% gain after a 55% decline still leaves you about 40 percent below where you were before the market cratered. Whether or not we are truly headed out of this recession is beyond my knowledge.
From BenefitJack: Behavioral economics studies confirm the role “loss aversion” plays in many facets of life, including investing.
I have a separate question about DCA. In the 11/18/10 Wall Street Journal, Professor Malkiel stated “buy and hold” is still a winner, in part due to techniques such as “dollar cost averaging” and “rebalancing”. As a benefits professional, with 31 years of leadership experience with corporate savings plans (401(k)’s, etc.), I can see where DCA may work with index funds, where the changes in the index are infrequent in any given year. However, most 401(k)s have actively managed funds where average portfolio turnover might be 25% with some having turnover approaching or even exceeding 75%. My experience is that active managers don’t do a lot of “buy and hold”.
What materials do you have to show DCA works in a 401(k) with actively managed funds? If not, are there educational materials for 401(k) plans to explain DCA may work best with index funds and that DCA may not work as well (or not at all) with actively managed funds? This is particularly important as many new 401(k) participants often select or are defaulted to a qualified default investment alternative (often an actively managed target date fund or target maturity model). With the most recent studies comparing active and passive results, fiduciaries might be prompted to reconsider investment selection, or at least incorporate new disclosures.
Thx, BenefitJack