Dollar cost averaging is contributing money to an investment over time, rather than plunking in a big chunk at one time. You might designate a specific amount to be invested each month (or week, or quarter). Conversely, you might put in your whole amount at the beginning or end of year, or whenever you get that bonus or pension payout or inheritance. Which is better?
I was recently reading an investment article by a well-known academic. He used his model 12 asset portfolio and explored the option of investing $100 every month in that portfolio, for 25 years. The ending account value was $68,580 (your investment was $30,000 total). That didn’t look so hot to me, so I used an online investing calculator which gave an annualized return of 6.062%. He’s weighting each of the assets equally and rebalancing once a month (!!!) That gives him approximately a 65/35% balance in favor of equities. He is using 12 indexes, which as we all know are not directly investable—mutual funds will likely have a slightly lower performance because of management fees. And, without at least knowing the Standard Deviation, it’s hard to see how much risk an investor would be taking. ~6% is pretty standard a performance.
But there is one advantage of investing monthly—potentially it allows you to buy at a lower average cost per share. If you buy on any given day, you have only one chance in 252 market trading days of hitting either the highest or lowest day. If you invest monthly, you have 12 chances, but it’s still unlikely that you’ll hit the lowest or highest trading day, unless you are very, very unlucky—you’ve diversified your risk. Still, since the market is up more than it’s down, your share cost will increase over time (which is what you’re hoping for, in a way, if you want to make any money). Also, if you’re investing a specific amount of money, you’ll buy more shares when the investment is cheaper, and less when it’s expensive. Finally, setting up monthly investments has the advantage that you might actually DO it. Dithering usually results in skipping at times—and there is never a good time.
But what about if you get a lump sum? By reserving some portion, you’re losing all the dividends and capital gains payments made, if reinvested. Let’s say that instead of investing $100/month over 25 years, you had invested that $30,000 all at once in his asset portfolio, held it for 25 years, and earned 6.062% annually. If I’m pressing the buttons on my calculator correctly, you’d have $130,652.15, over 45% more—so dollar cost averaging a lump sum over time could cost you a lot. But managing $100 a month contribution into 12 assets over 25 years is a pretty daunting prospect—if you can even find funds that would allow you to contribute $8.33 a month to each fund. So, let’s look at something easier. What if you had put that $30,000 “inheritance” into just one balanced fund, say Vanguard Wellington (no investment recommendation intended). $30,000 invested on December 31, 1997 would have grown to $184,743.75 by December 31st, 2022, according to Morningstar. (I’m using the article’s measurement dates—Dec. 31, 2022 wasn’t a trading day.) I wish I could show you dollar cost averaging into VWELX, but it’s beyond my powers to calculate and the data obtainable—they only show 15 years, where the annualized return is 7.45%.
Those who are more skilled at statistics than I am may find these figures arguable (isn’t almost everything, depending on how you set it up?), so I refer you to this article. Investing regularly has the advantage that you might actually do it. But, while investing a large lump sum may require a big gulp and a leap of faith in the future (and some scary days of bad markets), you’re probably going to be better off than holding back anything in cash.