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Plan Well, Retire Well

Saving and investing your money

Does dollar cost averaging help or hinder investors?

A few weeks ago, a friend from the Illinois Credit Union League forwarded me a page from Money Magazine that she thought I'd find interesting. It was Idea #4 from Money's article, The 6 Best Investing Ideas You've Never Heard Of, advising "Don't invest in drips and drops. Go all in." It questioned the usefulness of dollar cost averaging. Smart Money magazine had also weighed in on the subject in May, with Dollar-Cost Averaging: Safety at a Price.

Dollar-cost-averaging is an investment strategy in which you purchase the same dollar amount of an investment on a regular basis (weekly, monthly, etc.) over a long period of time. My friend knows that I teach about dollar-cost-averaging in my workshops, and wondered what my thoughts would be about Money's contention that it is for "nervous Nellies" and hurts your investment return. To be fair, Money points out that using dollar cost averaging to invest a portion from each paycheck "makes perfect sense." But the tone of the article is definitely a criticism of DCA.

So here's my take.

Say Janet has $10,000. She wants to start investing, and chooses a mutual fund investing in US stocks. I agree with Money that Janet would probably be better off investing her lump sum all at once rather than spreading it out into a series of smaller purchases, since the general direction of the stock market is UP.

But in real life, there are at least three things that Janet could do, not just the two scenarios Money looked at.

  1. Janet could invest the entire $10,000 all at once.
  2. She could stash it in a bank account or a money market fund, and use dollar cost averaging to gradually invest the money. She might make purchases of $1000 a month for ten months, or $500 a week for 20 weeks, or $500 a day for 20 days, or some other schedule.
  3. Or – and here's what the Money article and the research they cite misses – the fear of an imminent drop in the stock market might keep her from EVER investing the money. This paralysis is a very real possibility, especially for a do-it-your-self investor or a novice. If the market is up on the day she planned to invest, she might think she missed her chance. If the market just dropped 5%, she may fear further drops and think it's too risky to invest. And so she sits on the sidelines, with the money earning .01% interest in a savings account. It's not hard to see that, in all probability, this is not a good long-term investment strategy.

Money chooses to label dollar cost averaging as a "psychological crutch rather than an investment strategy. Not that there's anything wrong with that." But I think they miss the fact that an investment strategy (investing a lump sum immediately) is useless if the investor can't make himself do it.

Dollar cost averaging, as Smart Money recognized, is as much a risk management technique as it is an investment strategy. Yes, managing risk means reducing the chances that you'll make a killing, at the same time it reduces the chance that you'll lose most of your money. But managing that risk could mean that the investor starts investing, and stays invested.

Many people doing dollar cost averaging are simply investing regular amounts from their paychecks into their 401(k)s and 403(b)s. They don't have a lump sum to start with, and they're doing collar cost averaging by default rather than by design. For once, here's something that actually works to the benefit of the "little guy" who doesn't have a bunch of money to start with. You can come out looking smart, even if you don't have a lot of money to do it with!

One thing I love about dollar cost averaging is that it takes away the need for an active decision of whether to invest or not each month or each payday. It removes human emotion as an element in the decision. And removing human emotion from investing decisions is a good thing. Without a systematic way of investing such as dollar cost averaging, many people would invest erratically or rarely, and probably end up investing much less than if they automatically invested a set amount each month. Plus, they'd probably spend a lot of time worrying. Automatic, systematic purchases avoids that.

In my workshops, I will continue to teach about dollar cost averaging. I will try to avoid saying that it will optimize your returns. But I will not tell people they're nervous Nellies if they use it. I'll tell them they're smart.

What do you think? Click on my name below and give me your take on dollar cost averaging.

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