Dollar-Cost Averaging: Good Advice That Doesn't Make Sense by Emily Murphy, CFP®
Submitted by Moller Financial Services on August 26th, 2019
Dollar-Cost Averaging: Good Advice That Doesn’t Make Sense by Emily Murphy, CFP®
Human beings are highly prone to making illogical economic decisions. As behavioral economist Dan Ariely put it, “Our irrational behaviors are neither random nor senseless – they are systematic and predictable”. The evidence shows that our emotions cause us to make mistakes with our finances, no matter how smart we are in other areas. Action to mitigate negative emotions should be a priority even if the action doesn’t make sense (i.e. is not mathematically optimal). An investment strategy called dollar-cost averaging can be used to demonstrate how a “non-optimal” action can be a very good choice.
Emotional Investing
It’s not easy to accept our own fallibility when it comes investing (overconfidence bias), but not doing so comes at an enormous cost. According to the independent investment research company Dalbar Inc., the average investor’s annualized returns over the last 20 years are lower than the average return of each asset class that he or she was invested in.¹ The difference in returns was driven primarily by poor market timing, or selling low and buying high. Market timing isn’t caused by ignorance; it’s a “predictably irrational” behavior.
Lump Sum Vs. Dollar-Cost
If you receive a large sum of cash and you decide to invest it, when is the best time to do so? Should you invest it all right away, invest it all at some point in the future, or dollar-cost average over time? Dollar-cost averaging is when you invest set portions systematically over a fixed time frame. There is a right and a wrong academic answer to that question, but devoid of the human context attached to the pile of cash I contend that answer is meaningless.
Instead, imagine that cash is $5,000,000 and it’s from the sale of your business. That check is the physical representation of years of your mental and physical exertion. That business was your biggest asset and now that check is most of your life savings. Now, no pressure or anything, but you need to decide how to manage that money to keep yourself afloat through the next four decades. Ideally, you would like to leave something behind as a legacy too. The market has been booming for a long time and you keep hearing that a crash is inevitable. What if you finally invest the money and it crashes the next day? Alternatively, since it feels as though the world is going crazy maybe you’ll just leave it in cash and wait for the inevitable downturn.
What The Studies Show
In this scenario, instead of investing a lump sum immediately or after the inevitable down turn you could dollar-cost-average the money into the market. Using a dollar-cost averaging strategy you could invest $416,667 every month for a year, for example, instead of $5,000,000 at once. That way you avoid some of the downside if things crash during the year, but you also partially participate in any upside.
That strategy tends to feel like the best option to investors, but does the research back that feeling up? Vanguard has conducted two studies analyzing the strategies and the results were the same in both: Two-thirds of the time, investing the lump sum right away out-performed dollar-cost averaging ², ³. The longer the time frame for dollar-cost averaging, the worse the returns: “Immediate investment of a lump sum outperformed a six-month series of investments in approximately 64% of the historical periods. Over a 36-month interval, immediate investment outperformed approximately 92% of the time”. The 2:1 chance of success for the lump sum investment is a very clear mathematical answer.
The study was careful to point out, however, that emotions should be taken in consideration. “For investors with a large cash balance on hand, the stakes are high. Out of worry that an investment will quickly lose value, they may gradually ease into the market. Such an approach can minimize feelings of regret by providing short-term, downside protection against a rapid decline in a portfolio’s value.” Psychologists Daniel Kahneman and Amos Tversky demonstrated that humans experience loss more negatively than they experience an equivalent gain positively, an effect they call “loss aversion”. Coincidentally, the relative strength of experiencing a gain to experiencing a loss is about 1:2.
A Different Calculation
Sticking with an investment strategy through the ups and downs of the market is crucial to long-term success so it’s paramount to prevent negative emotions that predictably lead to bad decisions. If I create a new equation that weights each strategy’s chance of success (2:1) by its relative loss aversion factor (1:2), the strategies are mathematically equal. I would suggest adding in another factor to more heavily weight the loss aversion due to its importance in investment success. Can I come up with an exact, empirically justifiable number? No. But I don’t think that’s necessary in order to know what to do here.
It’s crucial to know the math behind a decision and fully understand the trade-offs. I’m not advocating throwing that out but suggesting that understanding the numbers is a starting rather than a stopping point. Things that can’t be perfectly quantified, like human nature or personal values, are just as important. We don’t make much sense and the right choice, just like dollar-cost averaging the cash, only has to kind of make sense.
1 Dalbar, Inc. (2019). Quantitative Analysis of Investor Behavior.
