Are you a market timer? There are few more universally adopted investment rules than “Market Timing Doesn’t Work”. While almost everyone I know will admit that market timing does not work, almost everyone I know is a market timer to some degree.
Market timing is a method of making investment decisions that relies on some process other than fundamental valuation. The investor tries to profit by knowing when to get in the market and get out, but does not pay attention to much other than the calendar, price movements and emotion.
A more subtle but commonly overlooked form of market timing is “dollar cost averaging”. Dollar cost averaging is the practice of moving money from cash into another asset a little at a time. For example, buying $1,000 worth of a mutual fund each month for three years rather than buy $36,000 worth right now. The idea behind dollar cost averaging is that you will buy more shares of a stock or fund when they are cheap, and less when they are expensive. Over time, you end up with a lower average share cost and better investment returns.
This conclusion is nonsensical, and I will explain why. If you are buying a mutual fund, I certainly assume you are expecting the value of the fund to go up, on average. Why else buy it at all? If you expect it to go down, please do not buy the fund.
If the fund will go up in price over time, dollar cost averaging simply means that you are, on average, buying shares at ever-higher prices. You also miss out on gains and dividends you could have had on earlier share purchases. By any analysis, a decision to dollar cost average into a good investment increases the likelihood that you will have less money at the end of the holding period. Dollar cost averaging is simply a bet that the investment will decline in value.
Some would argue that dollar cost averaging is a form of insurance against falling share prices. You will be holding back some of your funds and will buy shares cheaper later on. Such thinking overlooks the effect of declining prices on the shares you already own. Here is an example of what happens when you dollar cost average during a period when share prices are cheaper later in the period.
Assume you had $100,000 to invest on August 1, 1996 and could have either invested it all in the S&P 500 at that time, or started dollar cost averaging from that date forward for 100 months at $1,000 per month. Assume also that, in the meantime, any un-invested money earned money market or T-Bill returns.
At the end of the 100-month period on November 30, 2004, the dollar-cost averaging strategy would have produced an ending balance of $141,000. This is an annualized return of 4.3 percent.
A strategy of simply investing the full $100,000 at the beginning would have produced an ending account balance of $209,000, for an annualized return of 8.9 percent.
Dollar cost averaging would have wiped out more than one third of your potential wealth. By dollar cost averaging, you would have done worse than both alternatives: staying in cash or buying the stocks.
While the time period I have used clearly favors full investment, there are other periods when dollar cost averaging might have produced better results. Such periods are extended bear markets. A dollar cost averaging strategy is a bear market strategy. If you believe that we are in the early years of a long bear market, then dollar cost averaging might be a safe strategy.
However, if you believe we are in an extended bear market for stocks, then perhaps you should seek investments other than stocks. Averaging your cost into a downward trending market only lessens the losses. It doesn’t earn positive returns.
I do not mean to confuse this form of dollar cost averaging with the simple and sensible practice of making periodic savings. By taking money out of each month’s paycheck, you are making small investments over time. However, the motivation behind this form of systematic investing is quite distinct from dollar cost averaging. In the savings scenario, you are simply making the maximum investment that you can as funds become available to do so; you have no alternatives.
If you find yourself reticent to make a given investment, perhaps the answer is to look for a better investment. Dollar cost averaging is generally not the answer to dealing with investment uncertainty.