Is Dollar-Cost Averaging A Rational Investing Strategy?
Chapter 26 of The Rational investor
Welcome to another installment of project “passive wealth,” where I will be releasing my next book on investing (working title: “The Rational Investor”) chapter by chapter to paid subscribers of Making of a Millionaire.
You can catch up on previous chapters of the book here.
Chapter 26: Is Dollar-Cost Averaging A Rational Investing Strategy?
The best time to start investing is right now.
If you have access to cash that you want to invest, there are two strategies you can take to invest it.
Lump-sum investing: Where you invest all of your investible cash immediately. If you had $10,000 to invest, you would invest the entire $10,000 right away.
Dollar-cost averaging: Where you slowly invest a certain amount of your investible cash over a pre-determined amount of time. If you had $10,000 to invest, you might invest $1,000 per month over a 10-month period.
You have probably read a lot of conflicting advice on which strategy is better. Better is a subjective term and most people would use the outcome rather than the thought process to determine which is “better.”
I can tell you which strategy is the rational choice; it’s lump-sum investing.
Dollar-cost averaging “feels” safe
Most of us are forced into dollar-cost averaging because we only have money to invest every time we get paid. That is not the type of dollar-cost averaging I am referring to. I am addressing the situation where someone has a pile of cash, and rather than investing it right away, they slowly invest it into the market.
There is only one reason someone would implement a dollar-cost averaging strategy; they are afraid.
They fear that they will put all of their money in the market, and then the market will crash. This situation does create a “behavioral risk,” where the investor experiences so much pain from watching their investment go down that they sell at the bottom and lock in a loss.
Here’s the thing. Whether you invest a pile of cash all at once or over a 10 or 12-month period, eventually, you face the same risk of a market crash. If you take one practical lesson away from this article, let it be this. If you aren’t comfortable investing a lump sum all at once, that is a signal that your portfolio is probably too risky for you to handle. This is your brain telling you that you might need to rethink your entire asset allocation.
The simplest explanation why lump sum investing beats dollar-cost averaging
The expected value of stocks is always higher than cash. This must always be true. If the expected value of holding cash were higher than stocks, the stock market would implode. Framed differently, why in the world would anyone hold stocks if they expected to make less money than holding cash?
This is a perfect opportunity to remind everyone how realized investment returns are calculated.
Realized returns= Expected returns + Unexpected returns.
Expected returns are the forecasted returns for the stock market. As we just reviewed, the expected returns are always higher than the expected return of holding cash.
Unexpected returns are what actually plays out in real life. They are unpredictable, highly volatile, and are what drive our realized returns.
Since we have no way of knowing what the unexpected returns will be going forward, we have to rely on our expected returns and our ability to absorb risk when making investment decisions.
Since the expected returns for stocks are always higher than holding cash, lump-sum investing maximizes our expected returns and is the rational strategy.