In most situations, we discourage clients from Dollar-Cost Averaging (DCA; also referred to as “averaging in”) lump sums of excess cash that are available for long-term investing.

To first define the term, DCA refers to dividing up the total amount to be invested across periodic purchases that are usually the same dollar size.  This technique is typically employed with the goal of reducing the odds of “buying at the top” of the market.

Note that we are not referring to using a portion of each paycheck to buy into the market (e.g., via 401(k) contributions), which some consider a form of DCA.  We are of course in favor of those types of systematic investments, the key contrast being that they are not purposely delaying deployment of available cash

There are two primary reasons we discourage DCA; one is mathematical, the other behavioral:

• Mathematical. DCA is a losing bet from a quantitative perspective.  For Geometric clients, each asset class included in your portfolio has a positive long-term expected return.  The overall portfolio’s expected return is of course positive as well.  Thus, the expected return of the portfolio is positive (and greater than returns on cash) every year, every month, and even every day.  This means that delaying deployment of cash (as DCA does) must have a negative expected return.  A study by Vanguard reinforces this math, finding that lump sum investing beats DCA approximately two-thirds of the time.
• Behavioral. The execution of DCA plans often goes awry – we have seen it happen several times.  For instance, consider the investor who has $180,000 in excess cash to deploy but is worried that the market is “overvalued.”  The investor may plan to deploy $60,000 at a time in three tranches at the beginning of each subsequent month.  However, when it comes time to deploy a tranche of cash, two things may have happened to throw the plan off course.  First, the market may have moved up since the DCA plan was developed.  In this situation, the investor will likely believe that the market is even more overvalued than before and may be even more hesitant to deploy cash.  Alternatively, the market may have declined significantly since the DCA plan was developed.  In this case, the negative sentiment that caused the investor’s initial concern has likely intensified, and they will be worried about further declines.  In either case, the investor is hesitant to deploy that tranche, and execution of the plan is in jeopardy.  In extreme situations, the cash never gets invested at all.

Of course, some investors will counter that they are willing to forego some expected return (after all, the returns in question are only “expected”) in exchange for avoiding the potential disappointment of seeing a large sum of money decrease in value soon after being invested.  Because there is an equal (or even slightly greater) chance of an increase, this is a good example of loss aversion, a cognitive bias that explains why the pain of a loss is more intense than the pleasure of an equivalent gain, sometimes dramatically so.  Psychological arguments matter and should be respected, and thus we do tolerate DCA plans in certain circumstances, but in those circumstances it’s important to acknowledge that we are doing it for psychological reasons, not mathematical.

Specifically, DCA may make sense when the sum to be invested is large relative to the size of the total portfolio and came about due to a one-off, non-recurring event (e.g., receipt of a large inheritance or sale of a home with significant embedded equity).  In these situations, we acknowledge that the pain associated with a sharp market drop shortly after the cash was invested may hurt more than it usually does and thus the psychological benefit of the DCA plan may outweigh the mathematical costs.  In contrast, when the sum in question arose through an event that will repeat (e.g., receipt of a bonus from one’s employer), using a DCA plan just increases the likelihood that the investor will waste time and energy on a similar plan the next time the event occurs.

Once an investor has a thoughtful investment plan in place (inclusive of how much cash they should be setting aside outside the portfolio to begin with), they will generally be better off forgetting that the DCA arrow is even in their quiver – the math certainly argues against it.