By Kristi De Rycke, Registered Assistant
Dollar-cost averaging is when you invest the same amount of money on a consistent basis. This occurs naturally in a 401k where you put a percentage away out of each paycheck. You determine where the money goes. For example, you may have 50% go to bond funds and 50% to stock funds. Dollar cost averaging makes sense as you are only getting a certain amount to invest every couple weeks or once a month when your pay comes in. People can also choose to dollar-cost average into an IRA, individual or joint account. They set up a certain amount to go into their account on a specific date every month. The maximum contribution for an IRA in 2021 is $6,000 for under 50 and $7,000 annually for 50 and older. You can do this in a one lump sum or set up dollar-cost averaging. This would equal up to $500 a month or $583 for 50 and older. Maybe you came into some money through a bonus or sale of something. Would you be better to put that lump sum into an investment right away or put say 10% in each month for 10 months? Let us weigh that discussion.
As everyone knows the prices of stocks and bonds go up and down with the market gyrations. If you had $10,000 (just for a round number) and you invested all $10,000 on the same day you would buy all shares at the share price or the price on that given day. For example, the XYZ Company’s share is $50. You would buy 200 shares excluding any trade costs. If you instead decided to spend 10% on the first of every month for 10 months you would buy a different amount of shares every time. Let’s say you decide to try this. The first month we said the price of the share is $50. You would purchase 20 shares at $50= $1,000. If the market goes down and the share price is $25, your $1,000 would buy 2x the amount of shares or 40 shares. This would be a big drop but makes it easier to understand the math. Let’s say on month 3 the price goes back to $50 and you purchase the 20 shares again like month 1. Hypothetically in month 4 this security went up significantly and it now costs $75 per share. You would only purchase a little over 13 shares. Then, you continue at the current market price until month 10 when all your $10,000 is invested. Which would be a better plan? That one is not as easy to answer. It really depends on the market. As you can see if the market goes down, you get to buy more shares. If the market goes up, you get to buy fewer shares. So, what should you do?
Dollar-cost averaging really benefits when people have a relatively small amount of money to invest (Donald Trump and Bill Gates can skip ahead to the next section). It is great for helping remain disciplined about saving for the future as it becomes routine. It takes the emotion out of investing as you are not looking for the best price. It is nearly impossible to time the market. FINRA points out that people trying to time the market may often fail by buying stocks at their highs and selling at their lows. You may be buying right before they drop and selling before the rebound. As we have talked about before, even the experts are often wrong at market predictions. Dollar-cost averaging can help you stick to a regimented investing schedule and avoid always trying to time the market. Sometimes, waiting for the “right” moment to get into the market can be paralyzing for investors and the money just remains in cash waiting for the just right moment.
Vanguard did research on which was better over time. They looked at the dates in the United States from 1926–2015. They compared if they would invest the cash in a balanced 60% stock/40% bond portfolio in 12 equal monthly installments or in one lump sum. 68% of the time the lump sum would have outperformed over the 12-month rolling period. That sounds like a clear winner but what if you are investing right now in a period that will be in the 32%?
The downfall to dollar-cost averaging includes trading costs when you purchase more frequently. However, with the competition to provide very low cost and sometimes no cost funds this is becoming less of an issue. Money.com had a great article discussing when to consider not dollar-cost averaging. They point out that if you look at your portfolio and you are no longer in your risk level, that you should consider making a fast change versus slowly over time. Let’s look at an example. If you thought you had a more moderate risk of 50% stocks and 50% bonds and you look at your portfolio only to realize that you are now 75% stocks and 25% bonds, this may not be the time to do things slowly. Do you have 10 or 12 months to gradually adjust your risk level back down? No one knows the future. What if the market has an adjustment of 20% drop or higher, you may regret waiting? The flip side would be that you realize you are more conservative than you had planned. Maybe you find you are at 50% stocks and 50% bonds and you want to be more like 75% stocks to potentially get growth on your portfolio. How will you feel if the market has a great 12-month upside and you had to keep purchasing your funds at a higher cost than if you had purchased them all when you discovered the imbalance? The time to match your funds to your risk level may be today.
More confused than you were before you started reading this. That is how I feel writing it. Unfortunately, the more I look into financial options and look at both sides, I can almost predict the answer to the question before I start. Should I do a 401K or a Roth 401K? It depends. Should I invest in a 401K or an IRA? It depends. Should I take out Social Security at 65 or my full retirement age? It depends. Should I do a lump sum investment or dollar cost averaging? It depends. I really like black and white. I do not like to spend time in gray land but that is where we are. When considering what you should do, think about what makes you the most comfortable and go that route. As with most decisions in life, you will not be able to view the results until you have chosen right or left at the fork in the road and actually walked the road. At that point, you can evaluate if it was a good choice but often not before.
According to a Bank rate survey, 1 in 5 working Americans are not saving anything for the future. Don’t let this decision prevent you from investing the money. Make a decision and be ok with it. What if you choose the lump sum and 5 years down the road you determine that you would have been better with dollar-cost averaging? You need to be ok with it and recognize that you made that decision with the information you have today and not the information that comes available tomorrow. Hindsight is always 20/20.
How do you set up dollar-cost averaging? You can set it up yourself through a brokerage account. You will first have to choose what investments you want your money to go into. You could consider choosing asset allocation or target date funds which are is a basket of stocks and bonds. You could also set up several funds across various asset classes. Make sure to match your risk tolerance to your overall risk level in the account. Then call the brokerage company to have a certain amount taken out of your bank account and transferred to that account on the same day of each month. Then you will need to set up what percentages of that contribution goes into what funds. You can also do this online if you are comfortable. You are always able to stop the contributions at any time in the future. Are you still not sure how you want to do it, consult a financial professional.
By Greg Johnson
Don’t let the fear of being wrong affect your decision to save and invest for your future. Hindsight is always 20/20 and I wish we could go back in time and change all the wrong decisions we made. The reality is you cannot, so commit to a plan and move forward. Whether you invest in a lump sum or dollar cost average you are still saving for your financial future and that is what is important.
Periodic investment plans do not assure a profit or protect against a loss in declining markets. Such plans involve continuous investment in securities regardless of fluctuating price levels. Investors should consider their financial ability to continue purchases through periods of low-price levels.
https://www.ssa.org/files/member/Financial%20Planning%20Perspectives%20Invest%20now%20or%20temporarily%20hold%20your%20cash....pdfFinancial Planning Perspectives Invest now or temporarily holds your cash? Daniel B. Berkowitz Andrew S. Clarke, CFA Christos Tasopoulos Maria A. Bruno, CFP 2016.