In the last post I explored the math behind DCA. I’m going to expand on that analysis and later address some of the real-world issues associated with investing lump sums of cash.
Exhibit 1 below adds bonds to the “DCA Advantage” analysis as well as 60/40 portfolio (60% stocks, 40% bonds). The bonds in this case are represented by the Vanguard Total Bond Market Index (VBMFX) – it’s a very broad index of investment-grade U.S. bonds and unlike many other bond index funds it has been around since 1986.
After including bonds, the DCA Advantage rules hold – DCA is good in the down market and bad in an up market. The results are what one would expect – adding bonds to the portfolio smoothes out the returns and reduces volatility. This holds true for the DCA Advantage part of the analysis as well. What’s most interesting to me is the revelation that DCA “eats away” about 20-25% of the cumulative return over the period in both stocks/bonds and the combined portfolio. That’s a pretty steep price for feeling a little more comfortable.
Exhibit 1 – Portfolio DCA Advantage and Cumulative Statistics
Of course, this 14 year period is just an example and is not necessarily representative of a “typical” experience. However, our conclusions from the previous post hold – Lump Sum should be the preferred investment method since markets (both stocks and bonds) have a strong upward bias.
While mathematically the case for Lump Sum is fairly clear, there are other factors affecting these decisions:
- Psychological / behavioral – it’s a hard thing to commit a large sum into the market all at once. There is certainly no shortage of headlines to keep investors nervous – Government Shutdown, Taper, Sequestration, Debt Ceiling, Syria, Obamacare to name just a few. Most of these come and go without any lasting impact on the markets.
- Waiting for a pullback – this is very common and can drive you crazy. Recently, the market keeps making new highs and investors feel like it “has to” pull back. So they wait and wait, then get frustrated and pull the trigger at the worst moment. Or when the pullback finally comes, it’s usually on the back of some disturbing news (see above) and few people actually take advantage of the opportunity to buy into the weakness.
- Business risk for financial advisors – it’s a hard thing to explain to a new client how your portfolio started out with a million and dropped to $800,000 in a few months due to inopportune timing. Not many advisors will admit to this, but using dollar-cost averaging is a “safer” approach for retaining new clients.
I follow a few simple rules to remain consistent and avoid frustration:
- If the money was invested before (401k rollover, advisor change, etc.), I put it right back in the market
- If it’s “new” cash (business sale, inheritance, etc.), I typically come up with a DCA schedule. This can take anywhere from 3 to 12 months to get fully invested. The timeframe depends on:
- Current market position – this one is subjective and tricky
- The amount involved relative to overall portfolio
- Frequency of the event – a one-off business sale vs. annual cash bonus
At the end of the day, you have to do what will get you invested. If it takes using dollar-cost averaging so be it.
One final thought: if you chose do DCA, set a schedule and stick to it. Do not get cute and try to time each little investment you make. It’s going to drive you crazy and you won’t do any better than following a pre-defined plan.
- To DCA or not to DCA: that is the question (planbynumbers.wordpress.com)