Imagine you are a person who is fully sold to the concept of investing, but who currently happens to sit on a significant amount of cash. This situation is not that uncommon – you may get there by selling a property, inheriting from a wealthy aunt, or helping a Nigerian prince with his affairs. But more often, you might just be a person who is new to investing and has so far put all available money into a savings account.
There are a few important questions in this situation an aspiring investor could ask, one of them being: „Should I invest everything right now, or should I do it gradually over some period of time?“ The latter approach is often called Dollar Cost Averaging *.
While it might seem intimidating at first, LSI is almost always the correct way to go. This is documented in numerous studies, e.g. here by Vanguard:
The conclusion from the articles is that while LSI did not always beat DCA, it gave better results significantly more often (e.g. LSI beat 12-month-DCA in about 2 out of 3 cases historically). And what is also important, that it is really difficult to find a pattern or a rule to identify situations when DCA would have an edge over LSI (without knowledge about the future).
You may look at the problem from a slightly different perspective: If DCA was the correct answer mathematically, it would also be the right strategy for anybody who is already fully invested (ignoring taxes here). „You should withdraw everything and then DCA it back over the next 12 months! And after you do that, withdraw it again and DCA it back…“ That is quite silly advice.
There is one scenario where DCA makes sense even when LSI is possible, but it has more to do with psychology than with the math of expected returns. It is when a new investor is unsure about their risk tolerance and wants to observe their reactions before they commit all available money into the market. If the investor finds they can’t sleep after a 5% downturn in the first month of their DCA period, they can still easily reconsider their target asset allocation and, for example, reduce the portfolio equity exposition in favor of bonds.
Yes, there could be a large drop coming next month. But it could also come after a year of rising stock prices. Or after 5 years. We could be quite certain that there will be some nerve-wracking drops in the future. But if you are confident in your investing strategy, bite the bullet and invest your available cash now. On the other hand, if you worry a lot about how many 20% drawdowns lurk ahead for your 100% equity portfolio, maybe you should reconsider your risk tolerance and asset allocation.
* Dollar Cost Averaging could also mean investing a fixed amount of money at regular intervals, as opposed to saving those regular investments and waiting for a “dip”. In this sense, without a significant initial amount of cash, DCA is a completely fine strategy.
This material is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation, or as a substitute for legal or tax counsel.