Most of the time, the market is going up, so historically the sooner you get the money in, the more it will make, but sometimes it doesn’t work that way, and you have to be willing to accept that risk or try to mitigate it somewhat with dollar cost averaging (DCA), which is where you put money in periodically over a period of time to keep you from getting all your money in at a peak, or guarantee you get an “average” price over some particular time period. This Vanguard research paper, this article by Michael Kitces, and this article by Larry Swedroe on the topic are well worth reading.
Investing a large amount in one go has entry-point risk, which is the risk of investing it all at a single point in time and then if there’s a crash right after, you face the full brunt of the risk eventuating, whereas spreading it out for instance into say 40-50% upfront and the rest over a couple of years would have the following outcomes –
- If there was a crash immediately, you faced the risk with half your money but can make up for it by buying cheap with your other half.
- If there was a crash in 1 year, you had 1 year of growth for half your money, plus still some money to buy cheap, together offsetting a lot of the loss.
- As a potential crash point moves further away, you had more invested and earning for longer to cushion the fall, reducing the impact of a crash.
Essentially it spreads out the risk.
Is this a good idea?
For someone nearing retirement and with a significantly large lump sum relative to their retirement goal/needs, it makes a lot of sense because they have less time to recover from a possible sustained bear market during the first few years of drawdown when they are at their financially most vulnerable period.
I would be less likely to do this for someone younger and further from retirement or with a smaller amount. Instead, I’d consider setting an allocation of stocks to bonds that you’re comfortable leaving invested even if there is a crash and then invest it all into that allocation. But if you’re just not comfortable emotionally with the idea of seeing it drop soon after putting in a lump sum, spreading it out is fine as long as you’re getting more and more of it in over time so it can start earning money.
How to DCA the right way
Let’s say you’ve decided to DCA. How do you do it properly?
The main problems with dollar cost averaging that we want to address are:
- Leaving the yet-to-be invested portion in cash earns nothing as you slowly add to your investment.
- The first half of the DCA period would have, on average, only 25% of your final desired equities allocation in equities meaning not enough was invested and earning money to be able to cushion any fall in value, making the first half of your DCA period simply pushing back your entry point risk.
- Adding funds over just 6-12 months is such a short time, that again, you’re mostly just pushing back your entry point risk.
So what we want to do is, right at the start, put in around half the desired equities and put the rest into bonds so that you’re fully invested immediately (but with a smaller stock allocation), and then glide up the stock allocation to the final desired allocation.
Here’s an example.
Say we decided on a target asset allocation of 60/40 (60% stocks and 40% bonds), and say we wanted to DCA into equities over 2 years.
We would invest it all right away but into maybe 40% stocks and the remaining 60% in bonds.
Then glide the allocation of stocks up by around 1% a month, and after 20 months, it would be up to the target allocation.
If the market dropped and pushed the actual allocation out by more than 5% from the target allocation or if the increased target allocation meant the actual allocation was out by more than 5%, we would rebalance to the desired allocation. This way, if there is a market drop, we would be selling more bonds to buy cheap equities to take advantage of the fall in equities, which is one of the biggest failings of dollar cost averaging.