The Myth Of Dollar Cost Averaging?”

We have heard several investors comment the last few weeks that they are not all that worried about the year long correction because they dollar cost average (“DCA”) into the market using their 401k or other retirement plan. Their thought is that they are investing regularly when the market is low and they will be ahead of the game when the market gets back to last year’s highs.

There are a couple of misconceptions about their statements. First is that DCA is a decision to make with a lump sum of money. Instead of putting a lump to work all at once and taking a chance that a major correction siphons a good chunk out of your portfolio, you would invest it periodically reducing the downside of that outcome. Investing monthly into a 401k is not a choice since your only choice is to invest monthly. Now if they took the lump sum they have in the 401k and put it into a money market fund and shifted periodically into an equity fund that would be a true form of DCA.

The second misconception is that DCA is a superior way to invest in the markets. This is a popular mantra put out by Wall Street, especially mutual fund companies, to ease the anxiety of decision making for investors and secure sales of their financial products. These types of sales ideas tend to become more prevalent when the market is behaving poorly. When the market is behaving well the advice tends to be you’d better get in because look what you have missed.

According to Errold Moody, a noted financial advisor, if you have money to invest as a lump sum, DCA actually produces a lower return than investing the money all at once. He notes that two researchers (Williams and Bacon) have discounted dollar cost averaging by statistically showing that putting all the funds in at one time out produces dollar cost averaging by two to one. They invested a theoretical sum in 90 day T-bills and moved into the S&P 500 over a year's period. They compared these results with investing all the funds at once- starting with different periods from 1926 to 1991. The lump sum approach returned an annualized return of about 12.75% while the dollar cost averaging was just 8.50%. Reducing the dollar cost averaging from once a month to three or four times per year also increased the return.

These figures make complete sense since the market is up about 70% of the time. We find it interesting that the advice of Wall Street is able to influence people to believe a certain strategy even when the odds favor them two to one to do the opposite? We have come to the conclusion that when Wall Street talks it is best to locate your wallet with a firm grip.

Ironically, if you were going to use a DCA program, this might be one of the more effective times in my estimation. With the weakness in the market this last week, we have a feeling we may retreat back to the November lows (about a 13% drop on the S&P 500 from current levels) or possibly even lower in the coming weeks. Just remember if you do use this strategy now to take advantage of a weak market, it is essentially a form of market timing. If you are going to use a form of market timing you may as well employ a program that can be out of the way in a market correction or even potentially profit from it.

This is a historic week for our country and we hope the optimism and new crew make for a healing of the financial/economic issues that plague our backdrop. Maybe the Obama administration can maneuver a soft landing like Sully did with that plane on the Hudson? It would be just as heroic in our eyes.