Dollar cost averaging doesn't work

-- | 25/11/2019 Text size Decrease

Related article: <a href="https://www.morningstar.com.au/learn/article/the-dollar-cost-averaging-myth-why-lump-sum-i/197410">The dollar-cost averaging myth: why lump sum investing usually wins</a> Ruth Saldanha: We've talked about dollar cost averaging (DCA) and why it's a myth that it works. But DCA is extremely popular with some financial advisors for several reasons, including risk reduction, getting in at low points in the market and financial discipline. A recent research publication finds that this is not the case. I'm here today with one of the coauthors of that research, Morningstar's Dr. Paul Kaplan. Paul, thank you so much for being here today. Paul Kaplan: Thank you. It's a pleasure to be here. Saldanha: To begin with, what exactly is dollar cost averaging? Kaplan: Dollar cost averaging is taking a lump sum of money, let's say, $1 million and instead of investing it right away into the market, breaking it up into small bits and investing it a little bit at a time. So, for example, I might take $1 million and invest it over a five-year period and every month put about $1,667 in. So, altogether putting together the $1 million. Now, dollar cost averaging should not be confused with systematic investing. Systematic investing is putting money into the market on a regular basis as that money becomes available to you. So, for example, if you have a group RRSP at your place of employment, then every month or out of every paycheck, your employer will, on your behalf, take some money out of your paycheck and put that into investments. Saldanha: So, at a broad level, why does DCA not work? Kaplan: Long-term investing works when you keep your money in the market for long periods of time. When you're doing dollar cost averaging, you're not keeping your money in the market over the full period of time. You are keeping much of your money out of the market for much of the time. So, you're not getting the full benefit of long-term investing. Furthermore, when you're dollar cost averaging, you're basically placing a bet. You're placing a bet that the market will be going down shortly after you get the money and that eventually the market will come back up towards the end of the period as you're putting more money into the market. Saldanha: One of the reasons for the popularity of DCA is that by staggering your investments, you increase the probability of getting in at a low point. Does that actually make sense? Does it make more sense to go a DCA approach rather than a lump sum? Kaplan: So, DCA only makes sense if the implicit forecast in DCA, namely, that the market is going to go down for a while and then come back up, has merit. But if you don't accept that forecast, then DCA really doesn't make sense. Now, can DCA outperform lump sum investing? Yes, it can. But in our study, we found that was only the case about 10% of the time. Saldanha: What about risk? Does it make sense to stagger investments to reduce risk? Kaplan: Well, it depends on how we define risk. In our study, we found that actually DCA can have more risk than lump sum investing, if by risk, we mean the uncertainty about the dollar-weighted return on your investment. So, we found that the dollar-weighted rate of return on a DCA strategy is actually a little bit more uncertain than the dollar-weighted return, which is also the time-weighted return on a lump sum investment. The way to control the risk of your portfolio is on how you build your portfolio. What asset classes do you use? How do you weight among the asset classes? What type of investments do you use? Controlling your risk should be part of the way you construct the portfolio, not how you time putting your money into the market. Saldanha: The final point that the research report does not really cover is discipline and DCA instills a sense of discipline in investors. Is that a point in favor of the DCA? Kaplan: No. Because what is it that we mean by discipline? I mean, we could argue, to be a disciplined investor means putting the money in the market as soon as you get it and not hesitating. Just put it in the market. So, that might occur in a lump sum. It also might occur in a systematic way such as in a group Registered Retirement Savings Plan where you're putting money out of your paycheck, each and every paycheck, into the market. Saldanha: Thank you so much for joining us today, Paul. Kaplan: Thank you. Saldanha: For Morningstar, I'm Ruth Saldanha.