Dollar-cost averaging is a popular strategy to avoid plopping a big lump sum into the stock market only to see the market (or your particular stocks) take a dive. But it’s usually not the best strategy. With dollar-cost averaging, if you receive an inheritance, a work bonus, proceeds from the sale of a house or other big infusion of cash, you take your time investing the money, spreading out purchases over regular intervals. What research actually shows is that long-term investors usually would be better off investing every dollar they intend to invest as soon as possible.
Why people tend to think dollar-cost averaging a lump sum is a good thing: If you spread out the investments, you will automatically buy relatively few shares of a stock or a fund when prices are high (because the same dollar investment buys fewer shares at high prices), and you automatically will buy relatively more shares when prices are low. And everyone knows that it’s better to buy low than to buy high.
Problem with the strategy: Historically, going back decades, the stock market has gone up far more often on an annual basis—about three-quarters of the time—than it has fallen. So, other things being equal, investing evenly over many months or years actually means that you are likely to buy shares at higher and higher prices, reducing your eventual overall return. So even though you won’t always be better off investing a lump sum immediately, the odds are in your favor of being better off if you do.
How to reduce the risk of lump-sum investing: Even though the odds are in your favor, it may not be best to invest an entire lump sum in stocks, which many investors do when they come into a windfall. Instead, you should apply the same allocations that you use in your overall long-term portfolio plan. For example, if your overall plan is to have 60% of your portfolio in stocks and 40% in bonds, you can split a lump-sum investment in the same manner.
Michael E. Kitces, CFP, partner and director of wealth management for Pinnacle Advisory Group, which oversees more than $1.8 billion in client assets, Columbia, Maryland (PinnacleAdvisory.com). He also is publisher of the financial-planning industry blog Nerd’s Eye View. Kitces.comDate: May 15, 2016 Publication: Bottom Line Personal