Listen to On the Minds of Investors
In this two part blog series, we explore the benefits of dollar cost averaging for retirement plan participants and cautious investors, while also highlighting its downsides when compared to a lump sum investing strategy. While much has been written in favor of and against dollar cost averaging, we believe it is critically important for retirement participants to systematically contribute a portion of their paycheck to their retirement, regardless of market conditions, in order to successfully reach their desired outcomes. Separate from this, however, investors with cash on the sidelines are more likely to achieve better returns by putting their money into the market all at once, rather than dollar cost averaging.
Dollar cost averaging (DCA): Investing predetermined, fixed dollar amounts over a period of time.
Lump sum investing (LSI): Investing a sum of capital immediately upon receipt. Lump sums can come from several different sources—a pension payout, inheritance, the sale of property or a business.
People naturally feel confident in what’s predictable and anxious in the face of what’s not – like owning cash versus investing in unpredictable markets. To manage that anxiety, investors often use a technique that can help ease those feelings: gradually easing into the markets rather than plunging in all at once. That tip-toeing strategy, taking gradual, routine and even steps is called dollar cost averaging (DCA). Its formulaic structure lets a person put on blinders and invest without fretting over short-term volatility, while limiting losses if markets correct.
We believe that the methodical approach of dollar cost averaging is appropriate for two types of individuals: retirement participants and anxious investors. It should be emphasized, however, that this investment approach is of critical importance and benefit to the former, much less so to the latter. DCA has been used by retirement plan participants to successfully build wealth by systematically investing a portion of each paycheck through their working lives.
Defined contribution plans are designed to grow wealth over time by capturing earned income at the source and redirecting it with each paycheck into a long-term investment strategy. As the chart shows, emerging from the global financial crisis (GFC), a hypothetical 60/40 stock/bond portfolio with periodic contributions recovered 6 months faster than a portfolio without contributions. In fact, this is how most participants behaved through this time period - 97% of participants– made no changes and systematically saved and invested without emotion. As markets fall, periodic investments help participants continue to add to their portfolios; by buying more shares at lower prices, this helps speed the recovery, and compound over time (as also shown by the pie chart).
As always, investors should use historical evidence to support their investment decision, not emotions, but anxiety can be hard for some people. For those investors feeling uneasy about markets, a DCA approach can help get those clients gradually get invested. However, investors would be wise to consider the implications of such a decision: cash sitting on the sidelines is continuously losing purchasing power and should markets perform well, a DCA strategy will forgo upside potential.
Portfolio returns: Equity compared to equity and fixed income blend with and without periodic contributions
October 31, 2007- August 31, 2020