Dollar-cost averaging offers little risk protection
By Todd Mason / Knight-Ridder Newspapers
Small investors have one advantage over their better-heeled counterparts. Those of us who do our investing on the monthly installment plan find it impossible to make major blunders.
If we pay too much one month, the ensuing contributions to our pension plans tend to even things out. The technique is called dollar-cost averaging in financespeak. It minimizes risk by spreading investment decisions over time.
But nothing stays the same, does it? Sooner or later, installment investors have a fair chunk of money to worry about. Suppose someone comes along and prods you into making unaccustomed decisions?
My co-workers at the Fort Worth, Texas, Star-Telegram know what I'm talking about. Our 401(k) plan is moving from Fidelity to Vanguard as a result of the recent sale of the newspaper. Fidelity cashed out our accounts a week ago. Quite soon, Vanguard will drop the whole enchilada into our designated funds there.
Dollar-cost averaging is still an option. You could, for example, park the money in a money market fund and move it gradually back into stocks.
But does the technique work as well for lump sums as it does for monthly investing regimens?
No, say two professors at Wright State University. Writing in the Journal of Financial Planning, they argue diving into the deep end works best in two years out of three.
The academics tested their theory over 65 years, 1926-91, comparing lump-sum investing against dollar-cost averaging over three-, six-and 12-month periods. They used the Standard & Poors 500 index to represent the stock market. In the averaging models, they parked money in Treasury bills.
The results? Taking the plunge beat 12-month averaging 64.5 percent of the time. It worked better than six-month averaging 62.4 percent of the time and better than three-month averaging 60.5 percent of the time.
History offers no guarantees, of course, but one lesson resonates through the years. Being in the stock market is far superior to not being in it.
The study shows dollar-cost averagers pay dearly for their caution. The typical gap in annual returns between the lump-sum approach and 12-month averaging amounted to 4.25 percentage points.
You're not convinced, are you? The study stopped before the last few, stellar years in the stock market. Surely, the market's lofty heights increase the odds that we're poised on an off year.
Nothing goes up forever. I've said myself, in late 1995, again in 1996 and several times this year. I expect to be right eventually. Until I can be more precise, I'm leaving my money where it does the most good -- invested in stocks.
Feel free to disagree. Caution is warranted if you're closing in on retirement and can't afford a nasty surprise, or if you have trouble sleeping when the market sheds 500 points in a single week. By all means consider dollar-cost averaging.
Keep the transition period as short as you can stand. In trials I ran on two six-month periods, averaging amounted to expensive insurance in one case and relatively ineffective protection in the other.
I started with two imaginary nest eggs of $50,000. I plunked the first nest egg straight into Vanguard Index 500. I parked the second in a money fund earning three-month T bill rates and eased it into the Vanguard fund, moving $8,333 a month plus the accumulated interest.
I picked two very different six-month periods in the market to test, using Morningstar's Principia software. Shock and dismay reigned in the first six months of 1994 as the Federal Reserve hiked interest rates repeatedly. In the same months this year, with a mellow Fed on the sidelines, stocks ran wild.
The results? Dollar-cost averaging narrowed my first-half 1994 losses to $1,000 compared to the Index 500's minus $1,730 for the same period. This year, dollar-cost averaging almost cut my gains in half to $8,300 compared to the Index 500's $15,050 plus.
There's no mystery here given the lopsided earning power of T bills and stocks. The former just don't earn enough to effectively moderate the wild swings of stocks in either direction.
Jump in. Stay in. Tune out the noise.
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(Todd Mason is a business columnist for the Fort Worth Star-Telegram.)