All in, or bit by bit?

Posted by on March 27, 2009 @ 9:28 am in Investing

There’s at least a theoretical mathematical argument that the best way to get into the market—assuming you have a lump of cash sitting in a money market, bank account, or CD—is to go “all in” without waiting.

This is due to several factors. One is the “time value” of money. Another is the fact that the direction of the markets is impossible to predict—but on average, historically, stocks have gone up twice as much as they’ve gone down. Based on that alone, the argument goes, it might mathematically seem better to invest everything at once than to apportion your investment over time. And with interest rates so low, there’s a real cost to having cash sit idle for long periods of time as you invest it bit by bit. There’s also the camp that says, “If investing really is a ‘random walk down Wall Street,’ what difference does it make if you invest all at once or gradually over time?”

Why, then, is dollar-cost averaging (DCA) generally presented as the recommended way for most people to invest? It comes down to human behavior.

DCA forces the discipline to continue to invest in good times and in bad. In a recent Wall Street Journal article, Brett Arends acknowledges that we all know we should “buy low” (and we all recognize that things are pretty low right now), but the fear of additional losses keeps many of us from making the decision to invest now.

Arends maintains that this is why DCA works so well. First, with DCA you aren’t waiting for the market to hit bottom—and trying to time the market is a losing proposition that Arends likens to trying to catch a falling knife. And keeping to the sharp implement theme, DCA helps take the edge off investing in both up and down markets: You won’t catch all of the downs, nor will you capture all of the upside.

Do people use DCA because they’re disciplined investors? Some probably are, but I think there may be a more basic reason: Its appeal is all about risk aversion. Most investors would rather avoid a 10% loss more than they’d like to make a 10% gain.

Quantitatively and mathematically, DCA may not seem like the best deal, but try telling that to investors who went “all in” last fall—or at any one of many other times when the market fell 20 to 40%. In hindsight, DCA would have been a great strategy.

Notes

• All investing is subject to risks.

• Past performance is not a guarantee of future results.

• Dollar-cost averaging does not guarantee that your investments will make a profit, nor does it protect you against losses when stock or bond prices are falling. You should also consider whether you would be willing to continue investing during a long downturn in the market, since dollar-cost averaging involves continuous investment in securities regardless of fluctuating price levels.

• The link to WSJ.com will open a new browser window. Vanguard accepts no responsibility for content appearing on third-party websites.

We invite your comments on this Vanguard Blog entry. Comments will be monitored and published at Vanguard’s discretion. Comments received prior to July 7, 2009 will not be published.

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