So, you waited until the last minute again to make your IRA contribution for the prior year. To give you the benefit of the doubt, you didn’t wait until the last minute. You made your contribution on April 1st, two weeks before the April 15th deadline. However, you did make your entire contribution at one time and ever since then, the markets seem to be falling. Ugh, doesn’t that always seem to be the case? Every time you invest money, the first move the market makes is down. You know what they say. If not for bad luck, you wouldn’t have any luck at all. Well maybe you could have avoided this situation by using dollar-cost averaging. Dollar-cost averaging is where an investor contributes a designated dollar amount at pre-determined, regular intervals. You’ve heard your financial advisor preach about dollar-cost averaging in the past. Maybe it’s the solution. While this time-tested strategy has been a favorite of financial professionals for some time now, a study by Vanguard, the mutual fund giant, suggests t at maybe it is not the best strategy after all.
Back in 2012, Vanguard created hysteria in the financial planning community when they advised investors, with a lump sum to invest, that it would be to their advantage to invest all of that money at one time instead of using dollarcost averaging. This was, obviously, contrary to everything financial planners had been preaching to their clients for several decades, dating back to the 1940’s, when the concept of dollar-cost averaging was first introduced. I mean, the numbers in Vanguard’s study may tell you one thing, but have you ever invested a large chunk of money only to have the market selloff over 20% immediately following. Ouch! That is a painful experience that number crunching, certainly, cannot replicate.
However, the numbers don’t lie. The Vanguard study showed that the above scenario is so uncommon, it should not be a factor. In their study, Vanguard used a $1 million and $20 million dollar investment and ran thousands of simulations over rolling 10-year periods dating back to 1926. They compared the returns of investing all of the money at once to dollar-cost averaging strategies ranging from six months to 3 years. What they found was: The longer investors took to invest their money, the lower their total return. For example, those who invested the entire lump sum at one time earned a higher total return than those investors who took a year to fully invest their money two-thirds of the time. Is this really that surprising? Another common saying in the financial community is, “It’s not timing the market. It’s time in the market”. It has been acknowledged for over 30 years that lump sum investing does have superior long-term returns.
So what about dollar-cost averaging? Why was the concept ever created in the first place? Dollar-cost averaging works best during periods of wild volatility. This was the ever created in the first place? Dollar-cost averaging works best during periods of wild volatility. This was the case in the 1930’s, which led to the creation of dollarcost averaging in the first place. It has also been the case recently, especially from January 1, 2000 to December 31, 2009, when the market was coined the “Lost Decade”. If you would have invested a lump sum on January 1, 2000, by December 31, 2009, you would have had less money than your original investment. In this kind of market environment, dollar-cost averaging ensures that investors buy more shares when the market is down and fewer shares when the market is high. You may even show a positive return in a market that is flat or slightly negative. However, this advantage is lost in a rising, positive market environment.
That being said, let’s not abandon dollar-cost averaging altogether. For many of my client’s, this is the only way they can invest. They may not be fortunate enough to have a lump sum to invest, and they need to regularly contribute to their accounts in smaller increments. For most of my client’s, we set these contributions up as automatic monthly deductions from their checking account, so they don’t have to think about it. This concept is largely what makes 401k plans so successful. The money is pulled from the investor’s paycheck before they even see it and over time it accumulates. In addition, there is the psychological element. As investors, we find losses to our portfolio more emotionally taxing than we find gains satisfying. This reduction of risk and peace of mind alone may be worth the underperformance.
At the end of the day, there were still several scenarios where dollar cost averaging beat lump sum investing in Vanguard’s study. And as I say so often, one size does not fit all in the world of investing. What is most important is that you sit down with a qualified financial planner and map out your individual and unique scenario. Then tailor your financial plan to your specific goals and objectives. Until you have done this, it is difficult to say which of these options is right for you. However, once you have a plan in place, you may just find that dollar-cost averaging is still the best solutions for you.