I was reading this article from CNN Money that I found rather interesting. The article is the answer to a question a reader had submitted. The question was “I have $600K in a money market that I plan to invest in Vanguard index funds. Should I put it in at once or dollar cost average in increments over a certain period of time?”
Fist of all, what is dollar cost averaging?
Dollar cost averaging is an investing technique intended to reduce exposure to risk associated with making a single large purchase. The idea is to spend a fixed dollar amount at regular intervals on a particular investment regardless of the share price. In this way, more shares are purchased when prices are low and fewer shares are bought when prices are high. The idea of dollar cost averaging is to guard against losing value shortly after making an investment.
Dollar cost averaging has been widely criticized by economists and academic finance researchers as more of a marketing gimmick than a sound investment strategy (a way to ease cautious investors into a market, investing more over time than they would do all at once). Numerous studies of real market performance, models, and theoretical analysis of the strategy have shown that in addition to having the admitted lower overall returns, dollar cost averaging does not even meaningfully reduce risk when compared to other strategies, even including a completely random investment strategy.
In purely mathematical terms, dollar cost averaging doesn’t seem to make much sense. However, in the article the author makes the point that many people don’t view their lives mathematically. He gives this example.
If you had put $600,000 in the market in March of 2000, it would have taken nearly a 50 percent hit two and a half years later. And if you were like most investors, the pain of this loss would have compelled you to sell long before the recovery began. Had you not sold, you would likely have seen your global set of index funds delivering some pretty decent returns over the total period.
The author makes the point that when investing a large sum of money, there are lots of psychological factors at work. It’s important to get things right when it comes to investing. The more inconsistent we are, the more we tend to time the market wrong. So if you can’t be right, at least be consistent.