After weeks like this past one, with the stock market dropping like a lead weight, you will be hearing more about investing strategies that make it easier to sleep at night.
One popular strategy is dollar-cost averaging, an approach in which you dribble money gradually into the market rather than risk your entire wad in a lump sum.
Nobody likes to see their account drop 4% or 5%, perhaps more, just a day or two after they put a big chunk of cash to work. That’s what dollar-cost averaging aims to avoid. By purchasing stocks or stock funds in equal dollar amounts at regular intervals, like once a week or monthly, you wind up paying a blending or averaging of prices.
Sometimes you buy in at high prices and sometimes at low prices, but you never put all your cash to work at what could be a cyclical market top.
Workers who invest through their 401(k) plans each pay period similarly are putting money to work in stock mutual funds or other assets, gradually and at various prices.
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Yet dollar-cost averaging comes under attack as a “myth” in a study that appears in the current quarterly issue of Morningstar magazine, which caters to professional advisers. The authors claim that you usually can generate higher returns by investing all at once rather than easing in, since the long-term trend for the U.S. stock market has been solidly higher.
“Historically, dollar-cost averaging produces lower long-term returns than does lump-sum investing,” wrote Morningstar researchers Maciej Kowara and Paul Kaplan.
That makes sense. If you assume stock prices will rise over time, then delaying your investments by sitting partly in cash means relinquishing some of those gains. Cash holdings such as money-market funds currently are yielding next to nothing.
Lump-sum investing usually pays
The authors tested their hypothesis by examining lump-sum investing versus dollar-cost averaging over thousands of periods of U.S. stock market performance dating to 1926, over intervals ranging from two months to 10 years. Lump-sum investing soundly outperformed most of the time, especially over longer periods, the authors found.
Over a typical 10-year period, for example, people pursuing dollar-cost averaging would have wound up with only about 70% of the account balance they could have achieved if instead they had invested all at once, in a lump sum.
“Dollar-cost averaging has a relatively small chance of beating lump-sum investing when the (goal) … is final wealth, especially over long time frames,” they wrote.
Again, this assertion rests of the assumption that the stock market will rise over time, including reinvested dividends in the performance numbers. The historical record has been solidly in favor of that happening.
Easing stress with stocks
Yet final wealth isn’t the only objective for most people. Rather, they want to participate in the stock market’s long-term rising trend without getting wiped out along the way — and without the fear of getting wiped out.
If higher returns were the only goal, then more people would juice up their investment returns by, say, buying stocks on margin, using borrowed funds. This is one way to earn more money over time, but it’s a risky strategy from which most people shy away.
One perceived advantage of dollar-cost averaging is that it gives people a lower-risk discipline or method under which to invest.
The article by Kowara and Kaplan doesn’t present a clear-cut argument on whether dollar-cost averaging helps to reduce risk. The authors contend the two strategies are roughly the same in terms of one risk measure — how widely investment returns are likely to vary. Investors don’t mind if their performance exceeds expectations on the upside, but they don’t like big negative surprises on the downside.
Sticking a toe in the market
Because risks and comfort levels do matter, dollar-cost averaging appeals to individuals who are inexperienced or fearful about putting a lot of money into the stock market all at once. Only about half of Americans own any stocks or stock funds, and one of the great challenges is getting them to buy in and stay the course, even when employers offer the lure of free money in the form of 401(k) matching funds.
David Robinson, a certified financial planner at RTS Private Wealth Management in Phoenix, said he recommends dollar-cost averaging for some clients, depending on the circumstances. It can work well with young adults and novice investors, Robinson said, and he often suggests it when people receive an inheritance or other large windfall.
“If they’re two years from retirement, you don’t typically tell them to put it all in now,” he said. “You want to manage (downside) volatility.”
An averaging strategy doesn’t need to span many years but can be compressed over shorter spans of perhaps three to six months, Robinson noted.
George Fraser of Retirement Benefits Group in Scottsdale also likes dollar-cost averaging, calling it simple and intuitive, especially for inexperienced investors including many 401(k) participants. “It helps to remove the emotion and provides a plan, which most people don’t have,” he said.
With dollar-cost averaging, a person investing a fixed sum of money will buy more shares if prices drop, Fraser said. That provides comfort during market downdrafts. Ironically, though, investors could wind up paying increasingly higher prices if stocks embark on a sustained uptrend, as Kowara and Kaplan noted in their study.
Reducing stress more timely issue now
The Morningstar article didn’t address fear, anxiety, regret or the many other emotions that are part of the investing reality for ordinary Americans and even professionals. It’s a notable omission because psychological issues discourage a lot of people from even sticking a toe in the stock market, let alone staying the course for decades.
The article’s findings in support of lump-sum investing clearly have merit if you want to maximize your investment returns over many years. Most of the time, you will fare better by investing all at once. That way, you give the stock market more time to do what it does best — outperform money-market funds and most other investments.
But dollar-cost averaging can make sense if you want to reduce your stress or anxiety and thereby stay on track in the stock market during turbulent times, like now.
Reach Wiles at [email protected] or 602-444-8616.