When I worked in trust investment management, we had a constant flow of new money coming in. And with every new account we had to decide…invest all at once, or dollar-cost average (DCA)?
This is also an important question for individual investors. Especially when you have a decent chunk of cash to invest. How you decide to invest can have serious consequences…go all in at the wrong time and you risk losing it all. But if you sit on your cash too long, you risk missing out on gains during bull markets. Let’s explore the basics of dollar-cost averaging versus market timing.
Dollar-Cost Averaging Basics
What is dollar-cost averaging? Dollar-cost averaging means buying into the markets over time at set intervals. It usually involves moving cash or cash equivalents into productive investments like stocks or bonds. So, you buy more shares when prices are low and few shares when prices are high. Generally, it helps to set up a schedule beforehand. Then you can usually automate the process, or at least remove the guesswork. So what are the pros and cons of dollar-cost averaging?
Pros: DCA is generally a safer. Using this method can help preserve capital in down markets. Automating the process of dollar cost averaging is also an advantage. If you have a 401(k) you are probably already using a DCA strategy…buying into your investments every two weeks or every time you get paid.
Cons: Some think it's too passive. If you DCA during bull markets, you might forgo capital gains while you sit on excess cash. It can also be difficult to maintain the discipline necessary to buy your investments on a regular basis. Automation helps.
Market Timing 101
What is market timing? Just what it sounds like. You try to get in and out of the market at the right time, predicting tops and bottoms and taking profits when you can. Here are the pros and cons:
Pros: Bigger gains. Market timing is a more aggressive technique. So, there is greater potential for capital gains. For example, it would have been a great idea to go all in to stocks right around March of 2009.
Cons: Bigger losses. More difficult and advanced strategy. Most people can’t call market tops and bottoms accurately forever. It can be dangerous if you go all in at the wrong time, specifically near market tops. Going all in on stocks in late 2007 would have been a bad decision.
Which is best, which one should you use? Some people like to market time, and some are successful at it. But market timing is better for investors that are more sophisticated. Dollar-cost averaging is good for newer investors since it’s a more passive approach, although it does take discipline to do correctly.
For example, let’s say you have $50,000 that you want to invest. You don’t feel comfortable investing all that money into the markets at once. So, you might set up a DCA plan to invest $5,000 into your existing investment portfolio every three months. On that schedule, you’d be fully invested after two and a half years. That way you might preserve your capital while slowly investing into the markets. If you wanted to be more aggressive, you could invest larger amounts over a shorter period. If you wanted to be more conservative you could invest smaller amounts over a longer period.
Or you could use market timing strategies. If markets looks dangerously high, you could sit on the cash for a while instead. Wait for the markets to pull back and then buy in when you think it’s bottomed out. But again…if you invest in a false bottom and commit all your capital at once you run the risk of large losses. You can adjust these strategies however you want. You can also combine the two…
Hybrid Investing Strategies
Maybe you think the markets are almost done with a bear phase and due for rebound. But you’re not exactly sure when that will happen. Instead of going all in, you could start easing into the markets on a normal DCA schedule. Then once you see markets get better you might commit a bigger chunk of cash….in addition to your regular DCA schedule. Or maybe start with accelerated DCA purchases for half a year, every month until you’ve invested what you want. Then after that you could revert back to your normal schedule once you've got your excess cash committed.
The point is, you can combine the best aspects of both strategies to your advantage. So…you can keep a regular DCA schedule and engage in market timing as well.
It’s hard to say which approach is best. DCA and market timing both have pluses and minuses. A lot of it has to do with your temperament. Are you an active investor who enjoys paying close attention to the markets? Then market timing might work for you. But if you're a more passive investor, dollar-cost averaging might be the way to go. Or, use a hybrid strategy and combine the two at different times.
What are your thoughts on market timing versus dollar-cost averaging?