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Dollar Cost Averaging vs. Lump Sum Investment
Posted By timparker On 04/23/2012 @ 12:10 pm In Personal Finance | 4 Comments
You’ve probably heard of dollar cost averaging. I do it down here in Florida when the ocean water starts to cool down in the fall. I start with just my toes in the water and over the course of ten minutes, I’m in up to my head. It doesn’t change anything about my situation other than my comfort level. If I were to run in to the water instead of taking a series of slow, tentative steps, I would be used to the water faster and enjoying my swim ten minutes earlier.
In many situations, your money works the same way. Dollar cost averaging is one of those well-known investing ideas that we’re all supposed to believe but it only works as intended for certain investors.
You and I can’t time the market. If we could, we would all be filthy rich but it isn’t possible. Dollar cost averaging allows us to buy or sell in small increments over time. This, in theory, takes market timing out of our investing decisions because we’re not trying to find the top or bottom of a market move. Most inexperienced investors will try to find the tops and bottoms but all will fail when their results are measured over a longer time frame. Even the relative few day traders that turn a profit don’t try to find tops and bottoms.
The problem I run in to when putting clients’ money to work is that there is never a perfect time. In bull-acting markets, it always seems overvalued and ready for a big drop. In bear-style markets, we know it’s going to go back up but if I buy now, there might be more pain ahead. The only slightly less anxious time to buy is when the market is moving sideways but even that indicates that at some point there will be an explosive move up or down. If I can capture an extra one or two percent for a client, it helps them from the very beginning and makes me look like a more astute investor than I am.
But statistics show that I’m just as likely to get it wrong as I am to get it right. It’s impossible to predict the market moves so if I wait too long, I’m losing out on dividend payments and regardless of what the market is doing, its medium term (two to five years) outlook is likely better than what cash or a treasury is paying.
Dollar cost averaging works well for stock traders. By its nature, stock trading is market timing. If a trade is going well, I can dollar cost average out of the position. Maybe I take the profits and keep the original investment intact. If it’s not going well but it hasn’t hit the price where I cut my losses completely, I can sell out of half the trade. I’m not advocating any trading strategies but dollar cost averaging removes the all or nothing mentality out of short term trading. Hedging can do that as well but that’s not what we’re exploring here.
Long term investors aren’t looking for short term gains. Short of a catastrophic event, they’re likely not going to take their money out of the market for decades. Because of this, they aren’t so much interested in short term valuations of their product. Getting all of the money in to the market where dividends are captured as quickly as possible is how consistent and sustainable wealth is created. Even one dividend payment compounded over 30 years is a significant sum of money. That one $50 dividend payment missed as a result of waiting for the perfect time turns in to more than $200 by the time a portfolio has to be liquidated.
For those reasons, I tell clients that we should get their money to work now. If they’re a little uneasy about running in to the ocean with their money, we put it to work a little more slowly but waiting for the perfect time doesn’t help your portfolio. You’ll never find it.
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