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When Dollar-Cost Averaging Makes Sense

This post is part of a package on dollar-cost averaging. To learn about the other side of the equation, see Wednesday's article, "When Dollar-Cost Averaging Doesn't Make Sense."
This is a question I get routinely: "I just received a large lump sum of money. Should I invest it all at once or spread the investment out over time?" You face the same problem if you sell during a bear market. The question is then: How do you re-enter the market?

Let's be clear about the benefits of dollar-cost averaging (DCA). As you'll see in my next post, the academic evidence clearly shows that DCA isn't the best strategy from a purely investment standpoint.

However, there's an argument to be made in its favor when it's the lesser of two evils -- if you simply can't "take the plunge" and invest all at once because you're sure that day would turn out to be the high not to be exceeded until the next millennium. That fear causes paralysis. If the market rises after your delay, you're likely to feel that if yesterday's prices were too high, how can you buy now at even higher prices? If the market falls, you may feel you can't buy now because the bear market you feared has now arrived. So once you've decided to not buy, exactly how do you reverse course?

I believe there's a solution to this dilemma that addresses both the logic and the emotional issues. I recommend writing down a business plan for your lump sum, complete with an investment schedule. The plan might look something like one of these alternatives.

  • Invest one-third immediately and then one-third in each of the next two months or quarters.
  • Invest one-quarter today and the remainder spread equally over the next three quarters.
  • Invest one-sixth each month for six months or every other month.
Once you create your schedule, sign the document and instruct your advisor (if you have one) to implement the plan, regardless of how the market performs. Otherwise, the latest headlines or guru forecasts might tempt you.

Having accomplished these objectives, you should adopt a "glass is half-full" perspective. If the market rises after your initial investment, you can feel good about how your portfolio has performed and how smart you were for not delaying investing. If, on the other hand, the market has fallen, you can feel good about the opportunity to now buy at lower prices and how smart you were for not putting all of your money in at one time. Either way, you win from a psychological perspective. Since emotions play an important role in how individuals view outcomes, this is an important consideration.

If you're convinced that a gradualist approach is the correct one, it's important to ask the following question: "Having made your initial partial investment, do you now want to see the market rise or fall?" The logical answer is that one should root for the market to fall so that one gets to make future investments at lower prices.

More on MoneyWatch:

Why Do Smart People Do Dumb Things? Why Private Equity May Not Be a Good Investment Does Waddell & Reed Back Up Its Claims? How Do You Beat 94 Percent of Mutual Funds? Join the Circus Why the "Sell in May" Strategy Is Bogus

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