Shownotes
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 26: Dollar Cost Averaging.
LEARNING: Invest all your money whenever you have it.
“If you want to put the odds in your favor, which is the best we can do because we don’t have clear crystal balls, you should put all your money in whenever you have it to invest.”
Larry Swedroe
In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 26: Dollar Cost Averaging.
Chapter 26: Dollar Cost Averaging
In this chapter, Larry discusses why lump sum investing is better than dollar cost averaging.
Should you invest your money all at once or spread it over time?
According to Larry, the issue of Dollar Cost Averaging (DCA) typically arises when an investor receives a large lump sum of money and wonders if they should invest it all at once or spread it over time. The same problem arises when an investor panics and sells when confronted with a bear market, but then there are two questions: How does the investor decide when it is safe to reenter the market? And does she reinvest all at once or by DCA?
Constantinides, a University of Chicago professor in the 1960s, studied this question. He demonstrated that DCA is an inferior strategy to lump sum investing. He termed it logically dumb as it makes no sense based on an expected return outcome. From a purely financial perspective, the logical answer is that if you have money to invest, you should always invest it whenever it’s available.
Another paper by John Knight and Lewis Mandell compared DCA to a buy-and-hold strategy. Then, it analyzed the strategies across a series of investor profiles from risk-averse to aggressive. They concluded that DCA had no advantage over the two alternative investment strategies. Combined with their graphical analysis, their numerical trial and empirical evidence favored optimal rebalancing and buy-and-hold strategy over dollar cost averaging. Optimal rebalancing refers to the strategy of adjusting the proportions of assets in a portfolio to maintain a desired level of risk and return.
Dollar cost averaging versus lump sum investing
Knight and Mandell conducted a backtest to compare the performance of DCA versus LSI (lump sum investing). Backtesting is a simulation technique to evaluate the performance of a trading strategy using historical data. They backtested the two strategies between 1926 and 2010. Transaction costs were ignored (favoring DCA, which involves more trading). The authors assumed the initial portfolio was $1 million in cash, and the only investment available was the S&P 500 Index:
- DCA Strategy: At the beginning of each month, one-twelfth of the initial portfolio was invested—the entire $1 million was invested by the end of the 12th month.
- LSI Strategy: The $1 million portfolio was invested on day one.
The study covered 781 rolling 20-year periods. The LSI strategy outperformed in 552 of them—over 70 percent of the time. In addition, in the roughly 30 percent of instances in which DCA outperformed, the magnitude of that outperformance was less than when LSI outperformed.
Specifically, during the 552 20-year periods in which LSI did better than DCA, the average cumulative outperformance was $940,301 on the initial $1 million investment. During the 229 periods in which DCA did better than LSI, the average cumulative outperformance was $769,311.
When dollar cost averaging is the better option
Larry notes that there is an argument to be made in favor of DCA when it is the lesser of two evils—when an investor cannot “take the plunge” because they are sure that if they were to invest all at one time, that day would turn out to be the high not exceeded until the next millennium. That fear causes paralysis.
If the market rises after they delay, how can they buy now at even higher prices? And if the market falls, how can they buy now because the bear market they feared has arrived? Once a decision has been made not to buy, how do you decide to buy?
There is a solution to this dilemma that addresses both the logical and the emotional issues. Larry advises an investor to write a business plan for their lump sum. The plan should lay out a schedule with regularly planned investments. The plan might look like one of these alternatives:
- Invest one-third of the investment immediately and invest the remainder one-third at a time during the next two months or the next two quarters.
- Invest one-quarter today and spread the remainder equally over the next three quarters.
- Invest one-sixth each month for six months or every other month.
Adopt a glass is half-full perspective
Having accomplished these objectives, Larry says, the investor should adopt a “glass is half full” perspective. If the market rises after the initial investment, they can feel good about how their portfolio has performed. She can also feel good about how smart she was not to delay investing.
If, on the other hand, the market has fallen, the investor can feel good about the opportunity they now have to buy at lower prices and about being smart enough not to have put all of their money in at one time. Either way, the investor wins from a psychological perspective. This is an important consideration because emotions play an essential role in how individuals view outcomes.
Lump sum investing is the way to go
While DCA may sometimes work, Larry insists that putting all your money at once gives you the best odds of having the most money. If you want to put the odds in your favor, which is the best we can do because we don’t have clear crystal balls, he says, you should put all your money in whenever you have it to invest. Unfortunately, despite all the evidence, investors and advisors still recommend DCA.
Further reading
- George Constantinides, “A Note On The SubOptimality Of Dollar Cost Averaging as an Investment Policy,” The Journal of Financial and Quantitative Analysis, June 1979.
- John Ross Knight and Lewis Mandell, “Nobody Gains From Dollar Cost Averaging: Analytical, Numerical and Empirical Results,” Financial Services Review, Volume 2, Issue 1 (1992-1993) pp. 1-71.
- Gerstein Fisher, “Does Dollar Cost Averaging Make Sense For Investors?” 2011.
Did you miss out on the previous chapters? Check them out:
Part I: How Markets Work: How Security Prices are Determined and Why It’s So Difficult to Outperform
- Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
- Enrich Your Future 02: How Markets Set Prices
- Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
- Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
- Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
- Enrich Your Future 06: Market Efficiency and the Case of Pete Rose
- Enrich Your Future 07: The Value of Security Analysis
- Enrich Your Future 08: High Economic Growth Doesn’t Always Mean High Stock Market Return
- Enrich Your Future 09: The Fed Model and the Money Illusion
Part II: Strategic Portfolio Decisions
- Enrich Your Future 10: You Won’t Beat the Market Even the Best Funds Don’t
- Enrich Your Future 11: Long-Term Outperformance Is Not Always Evidence of Skill
- Enrich Your Future 12: When Confronted With a Loser’s Game Do Not Play
- Enrich Your Future 13: Past Performance Is Not a Predictor of Future Performance
- Enrich Your Future 14: Stocks Are Risky No Matter How Long the Horizon
- Enrich Your Future 15: Individual Stocks Are Riskier Than You Believe
- Enrich Your Future 16: The Estimated Return Is Not Inevitable
- Enrich Your Future 17: Take a Portfolio Approach to Your Investments
- Enrich Your Future 18: Build a Portfolio That Can Withstand the Black Swans
- Enrich Your Future 19: The Gold Illusion: Why Investing in Gold May Not Be Safe
- Enrich Your Future 20: Passive Investing Is the Key to Prudent Wealth Management
Part III: Behavioral Finance: We Have Met the Enemy and He Is Us
- Enrich Your Future 21: Think You Can Beat the Market? Think Again
- Enrich Your Future 22: Some Risks Are Not Worth Taking
- Enrich Your Future 23: Seeing Through the Frame: Making Better Investment Decisions
- Enrich Your Future 24: Why Smart People Do Dumb Things
- Enrich Your Future 25: Stock Crashes Happen—Be Prepared
About Larry Swedroe
Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.
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Connect with Larry Swedroe
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- My Worst Investment Ever
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Transcripts
Andrew Stotz:
Andrew, fellow risk takers, this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedroe, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, now Larry stands out because he bridges both the academic research world and the practical investing world. And today we're diving into a chapter from his recent book, enrich your future, the keys to successful investing. And specifically, we're going through chapter 26 and the title is dollar cost averaging. Larry, take it away.
Larry Swedroe:
Yeah, this is one of my favorite topics, because it attacks a myth and investing that most people believe and lots of advisors push, and there is a little bit of good news on this story here, but it's mostly a behavioral benefit, not a reality that's a good investment strategy. So there's an interesting question that many people face. They get an inheritance, maybe their parents died, something like that. They sell a company, and now you've got, you know, cash. What do you do? Do you invest it all at once in your asset allocation, whatever it might be? Or do you put the money in what some people call dollar cost averaging. Other people say drip by drip. Just, you know, enter the market, and that way you avoid these big crashes. You're the using a Yiddish expression, you're the chamele or the shelmazo that the day you invest the market's going to crash, which is exactly what everyone is afraid of, right? Okay, so this question was studied very simply a paper written by a University of Chicago professor in the 1960s named Constantinides. And he said, It's dumb. Logically, it's dumb. It makes no sense from a expected return outcome. Okay, and he said very simply this, ask yourself, are stocks riskier than safe bonds? What's the answer? Riskier? They're riskier. That's why stocks have what's called an equity risk premium, right? It's true every single day, right? So every day you're out of the market, you're giving up an expected return. And therefore, and if you run the empirical data, look at various periods, and the vast, vast, vast majority of the time, you're ahead if you put the money all in at once. So the logical answer, from a purely financial perspective, must be, if I have money to invest, I should always invest it whenever it's available. End of discussion. Now, academics love to publish papers showing somebody else is wrong. In 60 plus years, no one has published a paper saying this is wrong, which gives you a hint that maybe Constantine 80s was right, and there are studies showing that, of course, he's right. Now, if you inherited the money on March, 1 of 2000 or October, 2007 of course, in hindsight, you would have been better off dollar cost averaging, but bear markets are infrequent, and therefore clearly the majority of the time you're going to be well ahead. The sales pitch is often, but you buy more shares when prices are down, so you should be ahead, but the math is wrong. It's just again, this simple common sense that every day there is an equity risk premium, and therefore every day you're out of the market, you're missing out on expected but not guarantee returns. In my books on financial planning, including my only God, you'll ever need for a successful and secure retirement. I point out that there is a psychological benefit, and where I would advise people to at least consider dollar cost averaging, but it's only for the people who are so afraid that they're the unlucky soul that the day they're going to put their money in the market will crash, or their biases, their view your Democrat and the US and Trump gets elected, and you're sure because of your bias. Prices that the stock market will crash, or if you were Republican and Biden got elected, or Obama, you're sure the Democrats will screw the economy up. So you don't invest. Okay, so you have your biases that could overcome. If that's the case and that prevents you from investing, then every day you're out of the market, you're giving up expected return, and you could be out a long time. Now, imagine it that Trump gets elected, and you're a Democrat, and the market goes up, as it did in 2016 now it's higher, but you didn't invest. In fact, maybe you sold the markets higher. How could you buy? Now, prices are even higher, and if it went down, you can't buy because you're sure it's gone lower. So once you make the decision not to buy, for whatever the reasons, it's very difficult to get know when to get in. It often will happen months or years later, after the market has gone straight up for some long period of time. So what I tell people is this, if you can't get over that bias, because you're concerned greatly, or you're sure you're the unlucky soul that the day you invest it's going to crash, here's what you should do. Take a piece of paper, write down a plan. I don't care what it is, just don't make the time frame very long. You could say, I'm going to put in 1/3 of my money every month for the next three months, 1/6 every six months, one quarter every quarter for the rest of the year. Don't make it more than a year, because most bear markets don't last that long. And then here's what I want you to do, if the market goes up, congratulate yourself for your brilliance, for at least investing one quarter, 1/3 1/6 Okay, and avoided not investing at all. And if the market went down, congratulate yourself on your brilliance, for avoiding putting all your money in at the same time. Either way, you were a genius, and you feel good about yourself, even though it was the wrong answer from a purely financial perspective, but we are human beings subject to behavioral biases, and if you know you're one of those people, then having $1 cost average plan that you write down and absolutely commit to turn it over to your Financial Advisor, your brother, your sister, a friend, and say you are to execute. And if I try to tell you to do something else, you have my permission to hit me over the head and go ahead and execute it anyway.
Andrew Stotz:
There's a couple of things that I was thinking about when I people ask me about this all the time and and I say, for most people, they're going to dollar cost average. And the reason is, they don't have a lump sum. For most, that's right, I get, you know, people get monthly income, and you should just be constantly trying to get your money into the market to get that long term equity exposure. So congratulations, you are probably doing dollar cost averaging. I would
Larry Swedroe:
say you're changing the phraseology. What you're doing is investing whenever you have cash, which is what I tell people do, you are not dollar cost average, right? You're not.
Andrew Stotz:
You only got $10,000 but I said I was only invest 1000 No, put the 10,000 in.
:
That's it. Yeah, that's different.
Andrew Stotz:
Always build your exposure to equity. You know, as early as you can in your life, you can never, no method of investing will beat that, because ultimately that ends up being a large amount of money early on in your life that's able to compound and get that equity return?
Larry Swedroe:
Well, I would just change what you said a little bit. I would not say no method of investing would beat that. Putting all your money at once gives you the best odds of having the most money. But imagine an investor in Egyptian stocks in 1900 or Japanese stocks in 1990 clearly, they were better off dollar cost averaging, but that's in hindsight. So it could work. But if you want to put the odds in your favor, which is the best we can do, because we don't have clear crystal balls, you should put all your money in whenever you have it to invest.
Andrew Stotz:
Yeah, and let's say that you've already worked out. I think you know one of the key things is working out the instrument or instruments or methodology that you're following. Is that just a simple index fund? Is it a US index fund? Is it a global index fund? Is it a combination of that? At plus some of the factors that you know, exposure that you built. But once you've got that set, then you know. Now what we're talking about is you know where to go now. So first thing, as I said, many people don't really even have this choice because they don't have a lump sum. So really, what we're talking about is people who have a lump sum. And the point is that lump sum should would always benefit over time if you put it in now, let not just go
Larry Swedroe:
back again. You're it's giving you the best odds of success. It's not a guarantee to be the best strategy, but we don't want to confuse strategy with outcomes or engage in resulting. If you put it in all at once, that's the right strategy, because the best you could do is put the odds in your favor if it turns out to be March 1 of 2000 you got bad luck. Doesn't mean it was the wrong strategy,
Andrew Stotz:
and that's where, you know, people like to think they have more control over the market, and they because we're talking about another element, which is the element of, I'm going to time the market. Yeah, okay, if you think you're going to do and when you talked about your solution, as you mentioned about, okay, fine, come up with a one year plan that's not for the purposes of timing the market. It's really for the purpose of overcoming your behavioral
:Yes, exactly right. Yeah, okay, exactly right.
Andrew Stotz:
And I was just looking at the research on dollar cost averaging, and you highlight that in there, but I was just going back that that paper by Constantinides was in 1979 nobody, okay, yep, nobody gains from Dollar cost averaging was in 1992 that's Mandel Knight. And Mandel the fallacy of dollar cost averaging in 1994 by Thor Lee, a continuous time re examination of inefficiency of dollar cost averaging in 2003 and that was mill Veski and Paul Posner. And another look at dollar cost averaging in $2,018 cost averaging the trade off between risk and return. And now, well, I remember many, many years ago reading a book called Value averaging, and somebody has come up in 2011 with enhanced dollar cost averaging, and in 2023 we have smart DCA superiority. Any thoughts on those?
Larry Swedroe:
Yeah, the answer is simple, if you believe markets provide a risk adjusted return or not, okay, it's like saying this, if the PE ratios are high, you shouldn't invest. Well, that turns out to be wrong. It just means that the equity risk premium is smaller, but there's still an equity risk premium. It goes to our same argument we discussed last week on the Sell in May strategy. Yeah, stocks do perform worse from May through October, but there is still, in fact, they perform about half as strong as they do the first the other six months, but there's still an equity risk premium, so you're better off investing. Like I said, there's not a paper that I'm aware of anyway that contradicts Constantinides paper, which was done almost 50 years
Andrew Stotz:
Yeah. Ma'am, excellent. Well, that's a great discussion on dollar cost averaging. I know for some people, they haven't thought about it in detail. This gives you some background on how to think about it. Larry, I want to thank you again for another great discussion, and I'm looking forward to the next chapter. And the next chapter is chapter 27 Pascal's weight. Wag, wager, sorry. Wager, yeah, wait and the making of prudent decision, Pascal. Is he the guy that said that I would have written you a shorter letter, but I didn't have the time.
Larry Swedroe:
I don't know. He may have been, I think he was a French mathematician. Yes,
Andrew Stotz:
I think he was, but I'll have to check that by the time we meet again. Alright,
Larry Swedroe:
we'll discuss his famous analogy, which teaches people how to think about wagers or investment decisions, or any decision, if you'll remind me, I'll tell you the story about how what I did when I gave each of my daughters was old enough to drive a car and and we'll use the Pascal's Wager to explain their behavior.
Andrew Stotz:
Perfect. I look forward to it. And ladies and gentlemen, you can find Larry on X Twitter, at Larry swedro, and also on LinkedIn. This is your worst podcast. Was Andrew start saying, I'll see you on the upside. You.