Everything You Need to Know About Dollar-Cost Averaging: Why and How Long to Dollar-Cost Average Your Investable Funds

What is dollar cost averaging?

Dollar cost averaging is the process of buying into a security over time in equal installments. The action helps investors to not fear buy or sell at the wrong time. Investors may benefit from extreme market but the process is not guaranteed to outperform investing the entire sum. Because markets rise more than they fall dollar cost averaging will generally result in purchases slightly north of an average market price.

A detailed analysis as to why many if not most investors should dollar cost average:

To further explain why an investor should use this practice let’s use the example of two hypothetical investors. Jane and Joe.

Jane investor buys a house

• Jane investor doesn’t understand public markets but buys a home for the family. She determines that the home she wants to buy is selling at a fair price. She expects the home’s value will rise annually about 1.5% above the rate of inflation and she is satisfied with the purchase. With equity put in the home instead of renting, she expects a return of about 6% when she eventually downsizes and sells the home.
• Jane knows that the consistent amount of cash paid towards the mortgage every month is a reasonable store of value.
• It never crosses Jane’s mind to get a daily market quotation on the property and no one is dropping by the house regularly to give updates on its market value.
• Jane’ home value never materially fluctuates through her time owning the property even through multiple recessions.
• She continues down this path and her real return over 30 years matches the 6% figure.

Joe investor ‘plays the market’

• Joe investor buys a well-diversified index fund trading in the public markets at a multiple of earnings north of 12 with the hope of capital appreciation and future dividend payments. He has read that the S&P returns 11.2% over its average entire history.
• He correctly assumes that in 15+ years the index will produce roughly the market rate of return and grow at the rate of GDP over an extended period of time. Companies in aggregate are getting more efficient at allocating capital, meaning the returns will compound for a very long time into the future. The anticipated return is many basis points more than Jane or Joe’s house.
• Joe elects to get a market price quotation in his inbox every. Some days the quotation is very high and Joe is proud of himself. Rarely, when big market events occur the quotation is incredibly and wildly low. And, in recessions the market price is often low for very extended periods of time and Joe becomes fearful.
• Because the market price fluctuates materially over many years, Joe frequently sold stock in the index when the price got too low because he was afraid it was going to crash. He bought much more of the index when the price was rising to new highs because he was worried about missing out on a further rally buying at higher average prices.
• Joe’s real return underperforms the market average index in aggregate over his 30 years of investment. The real result is closer to Jane at a dismal 6%.

The above isn’t really a fake example as much as it is reality for most investors. Price actions are more often than not interpreted to be indicative of real changes in underlying value when they are not. The reason for Joes underperformance is simple, someone else bought when he sold and sold when he bought.

It is a misconception that returns from investing in securities follows a normal distribution, they do not. Market participants are not broken into clean categories of fifty percent winners and losers. Market returns are distributed asymmetrically.

Why wouldn’t real returns mirror patterns found in real life? Baseball, football, and all other fields of competition have well known all-stars that statistically have disproportionate success. Some athletes just outperform their peers on average. If true in sports, would the performance of a superior public company compared to all other public companies be much different? It isn’t.

Market reality is much closer to a pari-mutuel betting system, the same system in horse racing. All bets are placed together in a pool, the market. The house takes a cut in the form of exchanges, fund providers and clearing houses. Payoff odds are calculated by sharing the pool among all winning and losing bets, and the relative performance of each security. Payouts occur after the pool is closed each day. Buyers must commit to receive any reward but bear risk on every ticket. CEOs stand in for jockeys and companies for horses.

Incidentally, like horse racing, odds naturally favor jockeys and horses historically proven to perform. Companies with innate characteristics that make them likely to win generally do. Just like placing bets at the track, disproportionate rewards flow to those who bet on combinations with lower odds going into the race. Cheaper or out of favor securities, mispriced bets, can create asymmetric rewards. Losers are expensive companies that underperform over the long term.

Wealth is broadly created by businesses. It is unsurprising then that the bulk of results flow to successful owners. In a capitalist society, this should be the natural and desired result.

In light of the gambling elements of the market, the falsely loathed 1% own a disproportionate share of the wealth in their company. Most bets of the ultra-rich are the results of previously committed capital decades or a generation prior. To do so they provided the world with products or services that were better than what existed before. This in turn granted them the right to allocate more capital. Further analysis of business wealth creation id covered in our article on Reflections on The Sources of American Wealth.

The next class of return makers is the best investors. The people who receive the bulk of the prize pool. Not the average investor.

History shows that only the investors that make consist long term bets on the best companies at the best prices are disproportionate winners. Unlike Joe investor in our example, these skilled members of the investing public traded when prices were lower, and sold when prices were higher behaving contrary to Joe investor. Their unique set of behavioral and other characteristics position them to outperform the marginal investing class and rack-up asymmetric returns.

The marginal investor is the representative cumulative beliefs of all people trading a stock, and broadly represents everyone else. As a class of investors there are more of them than management, owners and super investors. Though their relative shares of total ownership are often small. The group as a class is Joe investor and their returns mirror his.

This raises the question, if you don’t fall into the class of the business owner or super investor how can you win? What should you do in a market system where the odds and share of rewards flow disproportionately to the other groups?

The answer for many investors is dollar cost averaging into a diversified set of funds to mirror as much of the fund’s performance as possible.

Who popularized dollar cost averaging and when?

One of the earliest major proponents of dollar cost averaging was The New York Stock Exchange. Benjamin Graham (1984 – 1986) published a book in  1949 titled, The Intelligent Investor. In Chapter 5, The Defensive Investor and Common stocks, he discussed a number of aspects related to how the marginal investor, or the ‘defensive investor’, should invest.

“The New York Stock Exchange has put considerable effort into popularizing its ‘monthly purchase plan’, under which an investor devotes the same dollar amount each month to buying one or more common stocks.

“During the predominantly rising-market experience since 1949 the results from such a procedure were certain to be highly satisfactory, especially since they prevented the practitioner from concentrating his buying at the wrong times.”

Graham goes onto cite back tested studies supporting the process and notes that the method offers a convenient and straightforward method to avoid behaviorisms of buying high and selling low.

For enterprising investors, the objective of dollar cost averaging may be to invest without moving the market. Purchases with a dollar cost average structure may be equally suited to not only combatting natural human weakness but also not alerting the marginal investor to a position being built in secret.

How should investors dollar cost average:

In most cases, dollar cost averaging follows the same pattern of work retirement investing. Purchases of the security or investment should occur in equal increments over an extended time horizon. The time horizon is discussed below.

Investing regularly available funds (a paycheck):

Most investors fall into the category of having regularly deployable funds from wage earnings. Folks participating in a company 401k plan make regular contributions are dollar cost averaging. Automatically allocating a portion of their paycheck into a set of securities over time.

For additional disposable funds beyond predefined retirement contribution percentages, investors who want to dollar cost average should simply mirror the process of their work retirement fund. Take excess funds and place them automatically in the most tax efficient vehicle available automatically. More frequent intervals of purchases will more naturally mirror the market price of the underlying security. Ideally done less frequent if the action incurs significant additional costs.

Investing a large or lump sum:

If an investor has an outsized sum of money to put to work, a debate exists between investing the sum all at once or over time. And if over time – what time horizon is ideal?

We have previously established that investor psychology creates tendencies that hurt returns. No great deal of science is required to prove that investing the lump sum has the greatest ability to generate the greatest return.

If the market is materially depressed, asset prices are at lows, interest rates are at historic highs and other marginal investors have misjudged the pricing of securities it is wholly possible that returns could be materially higher if investing occurs in a lump sum. We can say with certainty however, that the future is uncertain and it is impossible to predict what asset prices will do over the average investor’s entire time horizon.

The largest money managing institutions like Vanguard acknowledge the facts of this difference in performance. Lump sum investment also has the opportunity to create the most near term losses for investors who cannot stomach a plunge in prices. Investors who purchase over an extended period by contrast will have the general satisfaction of potentially buying at new lows and not dread purchasing at peaks.

How long should you dollar cost average?

There are major factors when considering how long to dollar cost average. Investment time horizon, retirement age and the percent of net worth invested are of primary consideration. The investor must  consider their situation. For the purposes of this discussion we will focus on solely on long term returns when approximating the length of time to enter the equities market using a dollar cost averaging.

Additionally, when considering the purchase of stocks or bonds, interest rates must be a factor of this discussion. Interest rate and debt cycles can have adverse effects on portfolios over long periods. For a summary discussion on what to buy and when read this post and the accompanying reference material.

Regarding the length of time to invest, this article by Bill Jones, a math professor and contributor to Efficient Frontier and other publications conducted a back tested study on equities determined that:

“DCA for 6 to 12 months is the most that one should use, and then only if moving more than 5% of your total assets (since even the worst case would cut your overall total returns by only 1% or so).”

“If you are shifting 30% or more of your total assets from cash to stock, you could take up to but no more than 18 months; this once-in-a-lifetime sort of situation merits overly-excessive caution.”

We qualify these results to say that past events are never predictive of the future which is unknowable. To repeat earlier points, DCA is for Joe investor, and is not about maximizing returns. It is about minimizing regret for most investors. Price is not the same thing as value and there are many factors that make future market price action unknowable. Mathematically, the market will rise more than it falls, we won’t try to contradict immutable logic.

Famous titans of finance such as Jack Bogle, the founder of Vanguard and Warren Buffett are on record stating this is the approach to take for Joe investor and are in favor of even longer time horizons for very large sums.

Summarizing and connecting the dots:

The message for the average investor is that dollar cost averaging can work.

• Dollar cost averaging is a way to avoid the phycological pitfalls that lead to overactive trading and the causes of material underperformance. If an investor does not truly know the value of the underlying security and understand nature of price movements it is one of the primary mechanisms most investors should consider using to invest.
• Selling and buying at inopportune times materially hurt performance.
• Market returns for investors don’t follow a normal distribution but instead mirror real life competitive closed pool betting systems.
• The upper end of returns will be captured disproportionately by business owners and investors of superior skill and not the marginal investor.
• Dollar cost averaging allows the marginal investor to take advantage of the swings in prices created by supply and demand forces and the whims of other marginal investors.
• Dollar cost averaging will result in a roughly higher average market price being purchased and will similarly result in roughly below the average market return for the security or index.
• Investors who dollar cost average and don’t fear price movements will be less likely to fall victim to whims of their own psychology. The process won’t always statistically provide the maximum return, but for Joe investor the risk of falling subject to fear may be reduced.

And that’s it. The results for most when investing is largely bound in psychology. The difficulty in achieving a nominal from the praxis systems that make fear and greed harder to execute upon. For Joe investor, dollar cost averaging is a beneficial but imperfect tool for combatting human nature.