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Thursday, 7 February 2008

Don’t buy into dollar-cost averaging

If you have a lump sum of cash, don’t invest it little by little. Decide on an asset allocation and buy in all at once, says Money Magazine’s Walter Updegrave.

Question: I’ve been putting money into a cash account each month for almost a year. I’m now ready to start investing this money - as well as my ongoing monthly contributions - in mutual funds. I want to capture lower prices and be able to buy more shares if the market moves lower. Do you have any advice on how I should make this transition from cash to mutual funds? –Ronnie Hall

Answer: This is the point where all fine upstanding financial journalists are supposed to extol the virtues of dollar-cost averaging - that is, tell you to transition into the market gradually by moving an equal portion of your stash each month from cash to mutual funds over the course of a year or so.

The supposed advantages of doing this is that you turn market volatility to your favor by automatically buying more shares when prices are low and fewer when prices are high.

But while dollar-cost averaging has risen to the level of accepted truth in many circles, it isn’t the magic bullet it’s made out to be. Indeed, some of the claims are simply an illusion.

So I’m going to break ranks here and recommend what I believe is a better strategy - namely, settle on a blend of stock and bond funds that makes sense given your risk tolerance and investing time frame, and invest it in that mix all at once.

But before I explain why I believe my approach is better, I want to be perfectly clear.

When I say I’m not an advocate of dollar-cost averaging, that doesn’t mean I’m against investing small amounts of money on a regular basis. That’s how most of us build a nest egg for retirement, making regular contributions via payroll deductions through 401(k)s or similar plans. This sort of systematic investing makes perfect sense, if for no other reason than it assures we save rather than spend the money.

But the concept behind dollar-cost averaging is different. The idea is that you have a lump sum that you could invest now, but you instead decide to invest gradually. And that’s the strategy I say doesn’t really hold water.

Forming a plan

To understand why, consider this scenario:

Let’s assume you have $60,000 to invest that’s been sitting in a money market fund or that you inherited from a relative or received as a job bonus. Before you invest a cent, the first thing you should do is ask yourself when you’re going to have to tap that investment. As I pointed out in a recent column, if you need the money within a couple of years, then you shouldn’t be investing it in stock or bond mutual funds at all. You should keep it in something secure, like a money-market fund or short-term CD.

But if you plan to invest longer term, you can afford to shoot for higher returns in mutual funds. The issue is, how much goes into stock funds and how much into bond funds? That’s a judgment call, but the longer the money will be invested and the more risk you’re willing to take, the more you can invest in stocks. You can easily get a recommended asset mix of stock and bond funds that takes your time horizon and appetite for risk into account by going to our Asset Allocator tool.

Assume that after checking out this tool, you decide that a portfolio of 60% stocks and 40% bonds gives you the right trade off of risk and return. The question then becomes, how do you go from $60,000 in cash to your 60-40 portfolio?

Well, if you believe in dollar-cost averaging, you would do so gradually. You might move $5,000 each month, investing $3,000 (or 60% of each monthly $5,000 chunk) in stock funds and $2,000 (40%) in bond funds. At the end of a year, your entire sixty grand would be invested in mutual funds.

Missing the target

But if you think about it, this approach doesn’t make sense. Over the course of the year, you would have actually been investing much more conservatively than you intended when you chose a 60-40 mix. The reason is that you’re holding on to so much cash, you’re virtually guaranteeing you won’t be at your 60-40 target mix for most of the year. By moving your money a little at a time, you’re actually undermining your investing strategy.

If, on the other hand, you do what I recommend - take your $60,000 and invest 60% in stock funds and 40% in bond funds (or whatever mix you choose) all at once - you’ll be invested exactly how you want to be from the very beginning. If you then do the same thing with any additional money you invest - and then rebalance your portfolio every year - you’ll maintain that same trade off between risk and reward.

I’m not guaranteeing that my method will lead to higher returns. But neither can the advocates of dollar-cost averaging. The returns you earn will depend on the financial markets. If the stock market surges, then putting your money in stock funds immediately will generate a higher return than investing in dribs and drabs. If the market heads south, the opposite would be true.

Hedging against uncertainty

The rub is that we don’t know what the financial markets will do. But that’s the whole point of creating a diversified mix of stock and bond funds. That’s the smart way to hedge against uncertainty. Once you’ve done that, there’s really no need to dollar-cost average. In fact, it’s counterproductive.

That said, I suppose there is one instance in which I could see dollar-cost averaging playing a role. If you’re so nervous about investing in stock and bond funds that you simply can’t do it without tiptoeing in, then you’re better off going in gradually than not investing at all.

Otherwise, though, the next time a market downturn triggers the obligatory chorus of praise for dollar-cost averaging, just tune it out.

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