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Wednesday, March 31, 2010

The Wrong Reason to Dollar-Cost Average

Pop writes about the intersection of our lives and economics at Pop Economics. There, you can find biweekly posts on everything from how your behavior affects your personal finance decisions to what the Fed’s most recent move means to you — not to mention some killer pop art. He recently wrote: Resistance is futile: Why buy-and-hold beats value investing.

The fact of the matter is: Most of us dollar-cost average when we invest because we have to. We get paid biweekly or monthly, and we invest our savings as soon as we receive it. We don’t have gigantic piles of money sitting around that we must choose to invest in a lump or over time.

But because dollar-cost averaging is personal finance 101, you’re going to find arguments as to why it’s the “best” way to invest anyway all over the place.

The refrain goes something like this: Let’s say that rather than put all your money into a mutual fund at once, you invest a set amount, say $1,000 per month, over time. When the fund is at $100 per share, you’ll buy 10 shares. When it’s at $150, you’ll only buy 7 or so shares. That way, you force yourself to buy more shares when they’re cheap and fewer when they’re expensive! You’ll see that argument at lots of reputable sites.

The problem with that explanation is that it suggests if you did have the choice between investing over time or all at once, you should invest over time. That doesn’t make sense, and here’s why.

Dollar-cost averaging1. Dollar-cost averaging works in reverse when you retire anyway.

Just as you might put $1,000 per month into stocks when you’re in the wealth accumulation stage of your life, you’re going to withdraw, say, $10,000 per month from your portfolio when you retire. And yes, that means you’ll be selling more shares when they’re cheap and fewer when they’re expensive — just the opposite of the supposed benefits dollar-cost averaging gave you when you started!

2. When you rebalance your assets as you age, it’s unrealistic to keep the strategy up.

Most of us invest a lot in stocks when we’re young and less in stocks (and more in bonds) as we age. Conventional wisdom holds that you should have, say, 90% in stocks and 10% in bonds when you’re in your 20s, but closer to 40% in stocks near retirement. But how do you get from one allocation to the other?

Dollar-cost averaging would seemingly dictate that you should slowly re-balance your portfolio as you age every month. In other words, when you hit, say, age 30, you’d sell a bit of your stock portfolio and buy a little bit of bonds each month as you got older. Aside from falling into the trap described in point one, how many of us could keep that up? And if we could, the transactional costs associated with the process, such as commissions from trading ETFs, would eat into our savings.

3. If you do have a lump-sum to invest, and choose to dollar-cost average, you’re throwing your asset allocation off, big time.

Pretend you’re in your 30s, have $100,000 saved so far in a 80/20 stock/bond mix, and come into a $100,000 inheritance. Hearing of the merits of the dollar-cost average approach, you choose to trickle the money into the stock market over time.

Well guess what? On day one, your asset allocation would be 40% stocks, 10% bonds, and 50% cash. Not exactly the aggressive asset allocation you intended, right? Just because you mentally put the $100,000 inheritance into a pile of money separate from your retirement savings doesn’t make it actually so.

And if you believe the stock market generally rises over long periods of time. The short-term volatility you’re trying to smooth out doesn’t matter anyway. The best time to invest will always be ASAP.

Something dollar-cost averaging is good at

At the end of the day, the completely rational individual would choose to make a lump-sum investment instead of to dollar-cost average. But exactly zero of us are completely rational. So there’s one big reason I can see someone choosing the DCA route, despite the arguments against.

In two words: “Loss aversion.” Humans fear losses more than they love gains. This tendency is well-documented by economists. So if you invested all $100,000 in a lump sum and the market dropped 5% the next day, you’d leave with an emotional scar. But alternately, if you began a DCA program and the market rocketed 5% the next day, you wouldn’t be nearly as sad.

That’s not rational — but it is the way we think. If you can’t get over that hump, you might decide that the cost of dollar-cost averaging is worth your emotional well-being. Just don’t pretend it’s making you money.