Now that the infernal summer heat has arrived in Florida, you will likely want to take a swim at the beach. But how will you get into the water? This question might not have occurred to you before, but the world is divided into two main camps on this dilemma – jumping in (which includes the “run and dive”approach) and wading in. The jumpers are more aggressive; they want to get the process over with quickly, experience some exhilaration, and then move forward. The waders take a more cautious approach; they prefer to move slowly, see how their bodies react to the temperature and, while they’re at it, hope to avoid contact with undersea predators and surface-dwelling tourists.
Now, if you have read our articles for a while, you know an investment analogy is coming, and here it is: There are also two well-defined schools of thought with respect to entering the rewarding (but sometimes shark-infested) world of capital markets.
Jumpers tend to favor “lump sum” investing, in which you take all the cash you intend to invest and put it in the market on the first available day. Waders, on the other hand, usually prefer a more conservative approach known as dollar cost averaging (DCA).
What Is Dollar Cost Averaging
Dollar cost averaging is an investment strategy in which you invest equal cash installments in fixed intervals over time, regardless of market conditions. DCA can apply to an individual stock, a basket of stocks or, in the case of a diversified investment strategy, the market as a whole.
For example, let’s say you inherit $1,000,000 from a wealthy relative but do not feel comfortable investing it all at once. Under a DCA approach, you could invest $100,000 each month for the next ten months, resulting in an investment price that is the average of the prices you paid over those ten months. This way, you reduce the risk of going “all in” to the market at precisely the wrong time.
Jump Right In
The intuitive appeal of DCA is straightforward. By gradually buying into the market rather than investing a lump sum, you reduce the risk of a painful loss if the market retreats right after you make your investment. And, as a significant bonus, if the market does drop after your initial DCA purchase, on your next purchase, you are able to buy additional shares of the same securities at a reduced price.
At first glance, DCA seems like a no-brainer; it offers reduced risk and the potential to buy additional shares at lower prices. The only problem with the DCA strategy is that it actually has a lower expected return than the lump sum strategy.
The reason for this is intuitively simple – if an investment has a positive expected return over time then, all else being equal, investing sooner is better and more rational because the full investment grows for longer. That being said, due to fluctuating securities prices, you could get lucky and benefit from a DCA strategy if the market takes a dive just after you invest. But according to The Vanguard Group, the empirical evidence suggests that lump sum investing is the more rational approach because it outperforms most of the time.
Irrational But Smart
We at Heritage have always been strong propon-ents of rationality in investing. In the context of the lump sum versus DCA debate, however, we allow our clients’ behavioral comfort level to drive the decision.
Although the lump sum approach has a higher expected return, we are comfortable with the DCA approach because it has lower expected regret. That is, purely rational investors jump in with both feet on the first day, and if the market has a sharp decline shortly thereafter, they accept the loss as an inevitable risk of lump sum investing and move forward. Perhaps that is true in theory but, in reality, humans are not built that way; regret is real and something to avoid. Therefore, given a choice between maximizing the potential for gain and reducing the potential for self-loathing, most people choose the latter, and this favors the DCA approach. As behavioral finance guru Meir Statman succinctly stated, “Dollar cost averaging is not rational, but it’s smart.”
Be Sure To Wear A Swimsuit
Most investors are subject to feelings of regret and, for this reason, we usually recommend wading into the market rather than jumping. However, regardless of whether you choose to wade or jump, it is much more important to have a well-articulated investment plan with a diversified portfolio of equities and some lower-risk assets to protect you when the stock market is in decline. Otherwise, you may not be prepared for the changing currents and, as our favorite investor Warren Buffet famously pointed out, “Only when the tide goes out do you discover who’s been swimming naked.”