Dollar Cost Averaging - Myth or Gospel?

You’re sitting with cash and maybe you missed the upside last year and maybe this is new money and you’re wondering how to get back into the market. You want to buy a few mutual funds for a long-term hold. You just don’t know if you should hold your nose and plunge right in or commit a little at a time, something even Suzie Orman says is a good thing to do and it’s called dollar cost averaging. Maybe these thoughts can help.

A few summers back a financial planner made millions writing a simple book about dollar cost averaging into mutual funds. He called his book, ‘The Automatic Millionaire’, and made some stretchable conclusions and observations that had people in the investment business in apoplexy. Summing up here are a few of his salient points:

• You will always earn an average of 10% per year.
• Start early enough and you’ll be a millionaire
• Pretty much all equity mutual funds are equal
• Even if you start late you’ll end up with a bundle

All the above are pretty much fairy tales and no one should take them as gospel. However, there is a ‘But’. In the world of investing there is always a ‘But’.

Dollar cost averaging is a systematic method of taking a fixed amount of money and investing it consistently into a mutual fund over a set period of time. The best example is the payroll deduction into an employer sponsored  401k. Most workers can only contribute to their retirement plan through a systematic savings so I’ll explore whether or not investors should do the same with their personal investments.

With the current market far below its high the question is whether an investor should now dollar cost average into a mutual fund or should he or she simply invest a lump sum of money? Which method would make the investor the most money?

The answer is – either and neither. Like the Viagra commercials it’s all in the timing. If someone invested a lump sum at the market high just before the 2008-2009 market collapse then that person has less today than someone who dollar cost averaged the same amount of money over the ensuing eighteen months.

Everything else being equal if you take the person who invested all of his or her money at the bottom of the crash versus someone who dollar cost averaged the same amount from then to now; in that case the lump sum investor is the winner. The problem is no one knows that ahead of time.

Dollar cost averaging does not guarantee that an investor will make more or less than an investor who makes a lump sum deposit. What it does do is provide more control over how much to invest and when to invest as compared to the investor who made a single deposit and is stuck with his timing and amount. Someone who is dollar cost averaging can also vary by increasing or decreasing the amount of money into the fund or funds, depending on what is happening in the world and take advantage of certain  situations.

Investors who dollar cost average complain that their investment performance is less then the actual fund performance and wonder why. Back in the 90s the average 401k investor barely eked out a return in the mid-single digit range when the average equity mutual fund was returning double digits. The reason was not the market but the length of time the money was invested. A fund measured performance over 12 months the investor only had  a small portion or 1/12th of their money invested for the full 12 months. The next deposit was 1/6th, the next 1/4 and so on. The final deposit had, in most cases, only had a few days to either earn or appreciate in value. In stellar years dollar cost averaging fund investors could not match those who made a lump sum deposit.

Except in rare occasions dollar cost averaging also has transaction costs or fees to pay on each deposit which also is not mentioned by the ‘Millionaire’ author. These costs reduce the total return. In a lump sum you have one and in systematic investment you have one on each and every deposit. The other problem is, as we have learned in previous blogs, there are only a few ‘special’ days that really make the entire investment year. If someone misses that moment with the bulk of his or her investment their portfolio will not come close to approximating what their funds return annually.

While I tend to agree, albeit reluctantly, with some financial writers that dollar cost averaging into mutual funds as an investment technique is not all what some would have us believe there is a definite benefit to investors.

• Allows investors with modest means to build substantial portfolios
• Smooth's out the investment economic bumps over the long term
• Eliminates the when to invest guessing game.
• Being able to start and stop contributions to control the amount of new money during an economic calamity and then being able to commit and redouble efforts when markets start to come back.

Most of us in the business do agree on one thing and that is the best time to invest is whenever we have the money to do so. When used as part of any investment plan dollar cost averaging can be a powerful weapon. It can make a small investor grow substantial assets and a large investor may use it to reduce share cost and increase total return if implemented properly.

There is also a psychological benefit that provides the dollar cost averaging investor control over future deposits while a lump sum investor may look on helplessly during times of extreme market volatility,

While dollar cost averaging may never make you a millionaire it is a simple method of investing in a world where complexity is beginning to be the norm rather than the exception.

If you have questions call Paul at 877 783 7080 or write him at pstanley@westminsterfinancial.com. Share this blog with someone who cares about their money.