This week, I received an email from a reader—let’s call him Tom. He described his experience managing through this year’s unruly market. After the market dropped in February and March, he said, the equities side of his portfolio lost a lot of value. So he decided to rebalance his account—that is, to buy stocks such that his original asset allocation would be restored. That is just what I would have done. But the key question and the key challenge—always, but especially this year—is timing.
With all of the doom-and-gloom news, Tom figured the market might be in a prolonged slump. So rather than buying stocks all at once, he set up a 52-week schedule for purchasing stocks in small increments. But after hitting bottom in late-March, the market quickly turned around and has since recouped nearly all its losses. Tom’s reaction: “In retrospect,” he said, his 52-week schedule was “too slow.”
Of course, to say “in retrospect” is the same as saying, “with the benefit of hindsight.” In other words, there’s no way Tom could have known that the market would bounce back so quickly. I don’t know a single person who predicted the lightning-fast recovery. So no one could call Tom’s go-slow decision a mistake. Still, it did give him pause. That’s why Tom wrote to ask if there was any better way he could have approached it. Below are a few thoughts on this topic.
Tom’s question fits into a broader category of question, which is: When you have a sum of money, whether it’s from a bonus, a windfall, an inheritance, or from rebalancing, how should you invest it? In general, there are two approaches: all at once or incrementally. The all-at-once approach is straightforward, but let’s take a closer look at the incremental approach, the approach that Tom took.
There are a variety of incremental approaches, the most common of which is called dollar-cost averaging (DCA). Investors often ask if there is an ideal way to structure a DCA plan. Does it make sense to invest in weekly increments, as Tom set out to do, or to opt for monthly increments? And what is the ideal time frame? Should a dollar-cost averaging plan span weeks, months, or even years?
It turns out that there is no scientific answer to this question—and that’s because dollar-cost averaging isn’t an evidence-based strategy. It’s what I would call a behavioral strategy. What do I mean by that? If you think about it, the stock market goes up more frequently than it goes down. In 69 of the past 95 years, in fact, the U.S. stock market has delivered a positive return. That’s more than 70% of the time. As a result, if you are planning to invest in the market, strictly according to the statistics, you’re much better off investing all at once rather than incrementally. That’s because the market is more likely to rise than to fall in the year after you invest.
Vanguard Group has analyzed this in detail. In a 2016 report, they studied a variety of markets and time periods and confirmed that “lump sum” investing beats dollar-cost averaging about two-thirds of the time.
But as I said, dollar-cost averaging is a behavioral strategy, and it’s a powerful one. Imagine, for example, if you had received a windfall in February of this year and if you had invested it in the stock market all at once. In less than six weeks, you would have seen 35% of your money evaporate. And just like Tom, you wouldn’t have had any assurance that it would return any time soon. That, in a nutshell, is the value of dollar-cost averaging. To be sure, events like the one we saw this year are unusual. But they’re not so unusual. As you may recall, the market dropped about 20% near the end of 2018. It recovered quickly in that case too, but other bear markets have been longer and more unpleasant.
This is why, despite the statistics, I still recommend dollar-cost averaging. But because it is not a principle that is based in math, the downside is that there is no scientific way to approach it. The only thing the data says is that, if you are going to go the route of dollar-cost averaging, the quicker the better. The longer you draw out an investing schedule, the more likely it is to work against you.
But that’s not all there is to say on this topic. Since I am an advocate of incremental investing, I’ll add a few more thoughts on how best to construct a schedule:
1. Since there is no ideal schedule, you should feel free to approach your investment schedule flexibly. In general, I think monthly investments are more manageable than weekly investments. But again, there is no science to it. What’s most important, in my view, is to choose a pace that is slow enough that you’ll be able to stick with it through market declines like we saw this year. That’s especially important because declines like that are a gift for dollar-cost averaging investors, and you wouldn’t want to miss out. In fact, it would largely defeat the purpose to stop investing during a market downturn since you’d end up buying only at higher prices.
2. While it’s important to stick to a schedule, I also think it’s a good idea to accelerate things if the market does decline. As I said, that’s a gift if it happens, so you might increase your monthly investments if a bear market comes along. There are lots of ways to do this. The simplest would be to simply double up your investments in months when the market is down. A more aggressive approach would be to ratchet up your investments in a way that is (inversely) proportional to market declines. In contrast to traditional dollar-cost averaging, which involves fixed monthly investments, this sort of ratchet approach would result in more dollars being invested when the market goes on sale.
Bottom line: Like most things in finance, I recommend keeping it simple. There are lots of more complicated approaches out there, such as value averaging, an idea that’s interesting but so complicated that it has little appeal in the real world. And since none of these techniques is based in science, there is no sense being too scientific about it. The “right” approach is the one that’s right for you.