“There is simply no telling how far stocks can fall in a short period… your mind may well become rattled by scary headlines and breathless commentary. And an unsettled mind will not make good decisions.”
- Warren Buffett, Berkshire Hathway 2017 shareholder letter
With stocks approaching a new historical record for the duration of a bull market dating back to March 2009, many investors are understandably anxious when deploying new capital. Bull markets invariably come to an end and many investors are concerned that a bear market could be imminent. Investing is rarely easy and these circumstances can make it particularly difficult for investors to feel confident about positioning new equity exposure.
The Real World Practicality of Behavioral Finance
Traditional economic theory assumes investors behave in a robot-like manner, making decisions without emotion that always maximize returns. However, behavioral finance shows that the vast majority of investors allow emotions and personal biases to drive investment decisions in a counter-productive manner. In other words, a $10,000 loss causes twice as much anxiety as the pleasure derived from a $10,000 windfall. The reality is that few investors have the ability to approach investment decisions in a truly objective manner.
Dollar-Cost Averaging vs. Lump Sum Investing
One perplexing question investors often face is whether to invest their capital all at once in the form of a lump sum or position it in fixed amounts at regular intervals – a strategy commonly referred to as dollar-cost averaging. Consider an investor who has just received an inheritance: she could invest the entire sum immediately or opt to invest at a fixed rate each month over the next 12 months.
A recent study found that investing the entire lump sum at once leads to slightly better returns. Practically speaking, however, many investors prefer the downside protection that dollar-cost averaging can provide.
The Case for Dollar-Cost Averaging: Downside Protection
Dollar-cost averaging is often used by employees deferring a portion of their salary into a 401(k) plan or by investors using a bank draft to save and invest on a monthly basis. The advantage of dollar-cost averaging is that it reduces portfolio fluctuation and dampens volatility, as stock market corrections allow for purchases at lower prices.
While the study found the difference between lump sum investing and dollar-cost averaging to be significant (on average lump sum investing outperforms by 2.3 percent cumulatively over a 10 year investment period), investors can make a fairly strong case in favor of dollar-cost averaging if they prioritize downside protection. The fact of the matter is that dollar-cost averaging outperforms in down markets, and foregoing some potential upside for better downside protection can be a worthwhile tradeoff.
In fact, dollar-cost averaging can be an effective way for investors to mitigate one of the practical flaws of lump sum investing – the mind’s tendency to make counter-productive decisions that are driven by loss aversion and volatility-induced emotions.
If you’re considering whether dollar-cost averaging makes sense for your portfolio, a CFP® professional can help to determine whether it is in your best interest.