In for a Dime, in for a Dollar

10/28/2008 12:00 pm EST

Focus: MARKETS

Tim Middleton, contributor to MSN Money, says investing all at once beats dollar cost averaging by a long shot.

One of investing's most treasured precepts—dollar-cost averaging (DCA)—is finding wider and wider acceptance. You do this automatically in your 401(k), contributing a fixed amount each month, whether stocks are up or down. Thus, in a period of volatility, you spread your risk.

But dollar-cost averaging is mind balm only. It doesn't actually reduce risk, and it doesn't increase returns. In fact, there's evidence that investors should approach the market more aggressively. Over short periods as well as long, investing lump sums is the equal of dollar-cost averaging, except in those rare times when the market is going straight up, when lump-sum investing does better.

I have done some research, and here's what I've found: DCA is pointless, except as a crutch.

[In ten years of investing,] there was no significant difference in the returns of the Vanguard 500 Index Fund (VFINX) [if] one investor put in $100 on the first day of every month [and] the other put in $1,200 on November 1st of each year.

Even in this disastrous year, when the fund itself has gone down 39.4% in the past 12 months, the lump-sum investor did only 1.5% worse than the DCA investor.

I chose ten years as my study period, [because] it reflects roughly five years each of bull and bear markets. In fact, the current bear market and that of 2000-02 are both monsters, marked by declines of more than 40%—the only time besides 1973-74 this has happened since the 1930s.

[Other] research has demonstrated that lump sums aren't just the equal of DCA but are instead superior to it.

Dimensional Fund Advisors, a firm that runs sophisticated index funds that are sold only through financial advisers it trains in-house, in 2004 studied four types of portfolios—domestic equity, domestic balanced, global equity, and global balanced—over periods dating to 1970 for foreign securities and to 1927 for domestic stocks and bonds. In the trials, one portfolio invested on the first day of each year, while the other invested quarterly.

"For the domestic portfolios during the 1927-2003 period, plunging [in at one time] beat wading in about two-thirds of the trials. The average one-year excess return of plunging over wading was nearly 6% for the domestic equity portfolio and about 4% for the domestic balanced portfolio," the study says.

"For global and domestic portfolios during the 1970-2003 period, plunging again beat wading in about two-thirds of the trials. The average excess returns for plunging over wading were about 4.5% for global equity, 3% for global balanced, 5% for domestic equity and 3.4% for domestic balanced."

Despite such evidence, most of the two dozen or so financial advisers I polled are strong supporters of DCA. I don't blame them. But if I had invested a bundle on October 1st, I would have gritted my teeth and held on. Ten years from now I'll be lucky if I can remember what happened in those ten days. And I would be sitting on a nice wad of money.

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