There are 2 ways to enter a swimming pool. You can walk yourself in slowly. Step by step. Inch by inch. Gradually edging yourself into the water so as not to be shocked by the cold. Or? You can dive right in without hesitation. Putting money to work in the capital markets is no different, leaving investors faced with the decision: is it better to wade or plunge?
One of the most common forms of periodic investing (i.e., wading) is called Dollar-Cost Averaging (DCA). DCA is a strategy that allows an investor to buy the same dollar amount of an investment on regular intervals, regardless of the price.
Participating in your employer’s company-sponsored retirement plan, like a 401(k), is one of the most common opportunities to Dollar-Cost Average. Money is deducted from your paycheck on a regular basis (e.g. twice a month or every other week) and it goes to purchase shares of whatever investments you’ve chosen, consistently, over time. The investments don’t stop if markets are turbulent. In fact, while clients often tell us that they wish they’d paid more attention to their 401(k)s, the hands-off approach actually works in their favor because the primary benefit of DCA is that it removes emotion from the investment process. You are committed to investing your money on a regular basis at pre-determined intervals – without worrying if the share price is up or down.
Manual investment programs increase the likelihood for the average investor to veer off their investment program and therefore take actions that work against them, such as suspending new contributions, panic selling during down markets, or altering their asset allocation to chase returns. We encourage clients to consider making investment or deposit decisions automatic, whether in their employer plan or outside because even the most resolute investor can be challenged by emotional reactions to short term market fluctuations.
The other approach is simply to invest all the available funds at once (i.e., plunging). Sometimes a client receives a large sum of money in the form of an inheritance, large bonus, or lump sum payout from a pension plan. If you are in the early or midpoint of your career, the academic evidence supports investment of these funds in one lump sum quickly rather than investing over a longer timeframe using DCA. However, if you receive a large sum of money later in your career, a more measured approach may be warranted. The markets don’t keep track of the timing of your retirement objectives, and you have less time to recover should you encounter an unfriendly market close to your retirement date.
For clients who aren’t quite ready to plunge, it is possible to DCA over a short, fixed time period. Oftentimes that gives investors the comfort of not investing a large sum of money all at once – but still requires them to take a disciplined, emotion-free approach. For example, a client might invest their lump sum at 3 intervals over a 6-9 month time period.
While dollar cost averaging may provide some protection or allow you to approach an appropriate risk level to meet your needs in this situation, risk management provided by an appropriate asset allocation is even more important. In addition, there are a lot of individual factors such as personal risk tolerance, timing of receipt, and your overall financial picture, which factor into how to best handle the investment of new cash. Our personalized approach allows us to explore these important decisions with you and come up with a plan unique to your financial situation.
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Please see our article that explores all of these issues in more detail.