Does dollar-cost averaging improve returns?

Michael Kitces is a Partner and the Director of Wealth Management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd’s Eye View. You can follow him on Twitter at @MichaelKitces.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Michael Kitces, he's a financial planning expert. We are going to talk about dollar-cost averaging and if it really helps improve either the risk or return to investors' portfolios.

Michael, thanks for joining me.

Michael Kitces: Great to be here; thanks, Jeremy.

Glaser: So I know a lot of people are probably familiar with dollar-cost averaging, but can you give us kind of the elevator pitch on what it means?

Kitces: So the basic idea of dollar-cost averaging says, I've got some money to invest and rather than putting it all in at once and taking the risk of what happens with the market immediately, I'm going to put it in systematically over time. I'm going to break it up and invest systematically over time. And as kind of the label of dollar-cost averaging implies, I'm going to do it with fixed dollar amounts. So, say I have got $10,000 to put in, instead of putting in $10,000 all at once, I'm going to put in $2,000 a month over the next five months.

Now by doing that, the mathematics start to work in your favor. If that investment goes up while you are waiting you end up buying fewer shares, because it costs a little bit more for your fixed $2,000 amount. If the investment goes down, you end up buying more shares because it was a little bit cheaper, so your $2,000 goes further. And what you end up with over the span of several months is often we find that the average cost of the shares ends up lower than they would have been buying all at once, simply because of the random market volatility and noise that happens along the way. So the idea of this is we're getting in systematically over time. We're buying fewer shares when they are up, we're buying more shares when they are down, that lets us get a lower average weighted cost. Ultimately that gets us a better upside potential in the long run for the investment.

Glaser: So if you have that lower cost, do you not actually get that higher upside, though? Why are you skeptical that this actually improves returns?

Kitces: So, there are problems with this from the return perspective. It's kind of a nice theory of, all right well if things go up then I buy fewer shares, and if things go down I buy more shares, and mathematically that’s true. But the challenge for dollar-cost averaging and some of the research they publish on this--the one big challenge is: Markets go up more than they go down. So we have to kind of figure out what's the odds-on bet. The odds-on bet is markets are going to go up. Which means if we wait--if we say dribble in the money evenly $2,000 a month over five months, the odds are actually good that we're going to end up doing more purchases when the stock was up and just get fewer shares than we would have by just buying it at the beginning.

So I did some analysis on this, looking at how markets behaved for the past 20 years and found this exact effect. When you actually look at, say, what's the benefit of dollar-cost averaging in over six or 12 months? What we ultimately find is about a quarter of the time dollar-cost averaging wins and the other three quarters of the time it loses. And when we look at what are that years that it actually wins, it turns out it's not entirely surprising in retrospect. It's years like 2000, 2001, 2002, 2008. Basically, if markets go down significantly for the year, no great surprise dollar-cost averaging looks great because you dribbled your dollars in more slowly, which means you got a bunch of your investment in at the end of the year after the investment had already fallen. But if we don’t actually know what year it's going go down in advance, we’re still stuck with this is a losing bet by about 3-to-1 ratio simply because markets go up more often than they go down.

Glaser: A lot of investors do worry a lot about that downside risk. You don’t want to be exposed when there are these big down years. Does this make sense as a risk-mitigation strategy then, to kind of protect yourself during these bad years?

Kitces: It does; it works a little bit better as a risk-mitigation strategy. If you want to view it that way, you can say look, dollar-cost averaging in over the next year is basically like saying I'm going to hold an elevated cash or bond position, whatever it is I'm dollar cost averaging out from, to get into wherever I'm going. If I hold more of something else in the meantime that’s something that’s maybe a cash or a bond that’s lower-volatility. I'm certainly ratcheting down my risk levels and so if my primary concern is, well I am just really worried about the risk of the markets and I want to come in more slowly. Dollar-cost averaging does work from the risk management perspective you will find over that year, you will have less volatility, you will have less downside exposure, simply because you didn’t own as much of the stuff. It does work from that perspective.

Now of course there is still kind of a double-edged sword here. If you are that convinced that the market is likely to go down for the year, of course, the best strategy isn't to dollar-cost average in through the year, the best strategy is to just not put your money in for that year. If you are that convinced that markets are going to go down. But if you are at least concerned about there is an elevated risk of it. I don’t really want to wait, but I am concerned about the potential. Dollar-cost averaging does kind of work as a midpoint on that scale and I think actually the best way to frame it--it's not even necessarily a great thing from a risk management perspective, but it's a highly effective tool from a regret minimization perspective. So if your driving concern is not, hey I want to maximize my dollars no matter what; my concern is, I just really don’t want to put dollars in and then go nuts a month or two from now if it turns out that markets just happen at an unlucky time to tank right after I put the money in. You can certainly manage your regret and minimize your regret by dripping dollars in over time. But just be cognizant that essentially you are paying with some upside, by choosing that risk minimization or regret minimization process of dollar-cost averaging in.

Glaser: Do you see signs investors are more likely to stick with their plan with the dollar-cost averaging program versus trying to just do lump sums when they have money available to them?

Kitces: It's been interesting how we see this play out in practice, and it's almost entirely driven by all these behavioral games, behavioral tricks that we have to sometimes play on ourselves to stay comfortable with markets and investing. We find that using dollar-cost averaging to help manage some of that regret concern works best when we really do get the lump sums that come in. Maybe that’s an inheritance, sadly a life insurance settlement if someone passed away. Maybe that liquidation of some business or investment. We got a whole bunch of money in cash, we do want to invest it, we're really concerned about the timing. It just helps us sleep a little better at night and reduce the regret concern by dollar-cost averaging in over time. You won't necessarily make more money in the long run most likely, but it comforts.

Glaser: There could be some situations where DCA still makes sense, but you should be aware of the costs.

Kitces: Yeah. But you need to be aware that you are doing it more to manage your regret than anything else and then that’s fine I don’t want to second guess anyone. If your choices are I can go all in if the market crashes I am going to freak out and sell everything when it's down, or I can dollar-cost average in and sleep better at night. Sleep well at night--you only get one life. So I don’t mean to knock it from that perspective, but just be cognizant that on average over time, it's really not actually a wealth-creating process. Now if you are investing systematically anyways because you earn X dollars and you are saving a certain amount every month. You will just get the benefit of the math of dollar-cost averaging along the way and it is what it is, because you are just investing the dollars that you have available. But in these scenarios where I've got a lump sum and I'm deliberately choosing not to put it all in at once, I'm going stretch it out over time, just be cognizant--it may be great to minimize some of your regret, and it does work from that perspective, but the odds-on bet is you are probably going to end up leaving money on the table.

Glaser: Michael, thanks for joining me today.

Kitces: My pleasure. Thanks.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.