Saturday, November 03, 2012

Dollar Cost Averaging vs. a Lump Sum

A Vanguard study (link1) is cited on Marketwatch (link2), saying that investing all at once gives better results over dollar cost averaging. The premise is a person inheriting a large sum of cash, or some other kind of windfall, such as selling a business, or winning a lottery. The edge for lump summing (investing all a once) tends to be measurable, though small.

It is worth thinking about. However, there are several caveats. The vast majority of stock market investors are not in that fortunate group making a decision about a large inheritance. Much more common are people making every day decisions with their every day savings. For example a person that has been in CDs for ten years and decides to plunge into the stock market, or bond market or gold market.

Those making "all in" or "all out" decisions tend to do poorly. While a few will do okay, many more will buy and sell at near the worst moments. This is how markets work, that at market tops there are a relative maximum number of buyers, at market bottoms a maximum number of sellers. A lot of those wrong-way buyers and sellers are small investors that feel the greed at the top and the fear at the bottom and act on it. NOTHING CAN CHANGE THAT. Markets make tops when a lot of people are buying, and bottom when a lot of people are selling. Those that think they can beat that, tend to be fooling themselves, or in an elite group with some special talent. Almost everyone making "all in" or "all out" decisions believes they are making a smart decision, but 80% to 90% are making terrible decisions.

So while the Vanguard study is interesting, it mostly applies to a person receiving a large sum out of the clear blue sky, not someone who is moving "all in" or "all out" because of news, or "just because." Another point is that dollar cost averaging can be a disastrous strategy during a prolonged bear market. Of course, no one thinks they are entering that territory when they start investing. Only in hindsight can we really say, that there was a 10 or 20 or 30 year long bear market in a certain asset class.

Another passive way to invest is to set an asset allocation and then rebalance as the various assets move up and down in value. This forces an investor to buy when prices are lower. The catch is that a person has to stick to their asset allocation. The permanent portfolio popularized by Harry Browne is one such approach (25% each to cash, bonds, stocks, gold). I am a fan of this approach. However, as always, there are no guarantees, but this kind of approach has done well for the past 30 years, with no need for bold decisions or market timing. Some will say that is because of the huge bull markets for gold and bonds and that is unlikely to be repeated. 

Another more common approach is a 50/50 stock and bond allocation, with a cash reserve of six months or a year that stays in cash. The big danger with this kind of approach are black swan events such as a change of government due to revolution or the loss of a major war, making all those paper assets virtually worthless. While the odds are low for any particular country in the short term, over the long term, these historic events do happen. Again, think back to 1900 and how many of the major powers (France, Germany, Russia, China, Japan and more) saw their governments fall and their bonds essentially go to zero before 1950. Equity investors did not do much better. Americans tend to ignore these kind of big risks because we have been blessed, but just like investment results, that is not guaranteed for the future.

My schedule continues to be too busy for much trading activity, and probably will be that way for the next two months. So I'll chime in when I can, but it won't be often.

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