Staying Fit
One of the questions I’m asked most frequently is whether to invest a large amount in the stock market immediately or to do it over time through a method known as dollar cost averaging (DCA). The answer is complicated, but you’ll generally be happier if you invest a set amount into the stock market at regular intervals — which is the definition of DCA.
Say you’ve come into a lot of money. You may have sold a business or some real estate or, sadly, inherited a sum of money. Let’s use a round number of $200,000, of which you want to put $100,000 into stocks such as a low-cost and diversified total stock index fund.
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You could put in the order to buy it all today or use DCA. For example, using DCA, you could invest $5,000 a month over the next 20 months. That way, if the stock market goes down, you’ll be buying more at a lower price. Of course, if the market goes up, you’ll be buying shares at a higher price. More on choosing the period of time in a bit.
I tell people that the mathematical answer is to take the plunge and put the full $100,000 into the market immediately. In the very long run, the stock market is likely to go up, meaning the odds are you will make more money by investing it all now. Therefore, getting to your target asset allocation more quickly is superior.
On the other hand, I also point out that we humans are not mathematical beings — we are emotional animals. Say you took the plunge today, and tomorrow ends up being the worst day in the history of the stock market. Or even in the beginning of this year before the bear market. Would you stay? Many people wouldn’t. And we know this because research demonstrates we get roughly twice the pain from losing a dollar as pleasure from gaining a dollar. In fact, Daniel Kahneman won a Nobel Prize in economics for this concept, known as prospect theory. With DCA, you don’t have to worry about such a worst-case scenario.
When and how to use DCA
First, I tell people when not to use DCA. If they are getting out of more expensive stock mutual funds or exchange traded funds (ETFs) into lower-cost ones, put it all in now. They are decreasing fees and not increasing risk, so there is no need for DCA. Second, if some of the money is going into high-quality bond funds, I tell them to take the plunge. In spite of bonds having one of the worst years in decades, stocks have lost more in a day than bonds have in a year.
