A good discussion came up in my previous post on my IRAs – Should I invest the $4,000 earmarked for my 2006 Roth IRA contribution all at once in January, or dollar-cost-average it over the entire year? Dollar Cost Averaging (DCA) involves investing a fixed amount at a regular interval. For my $4,000 example, I could invest $335 a month, every month, for 12 months. The idea is to buy more shares when the price is low, and and less shares when the prices are high. Sounds good, right? Maybe.
This question actually came up last year, but I didn’t research it very much. My own thoughts were that because the markets trend upwards overall, if you are investing for a long-term period you should get your money in as soon as possible. Sure, you might run into a huge drop, but you could just as easily (in fact more easily) miss a huge rise. But this is too hand-wavy, as scientists would say. I want numbers. So I found some.
Now, wouldn’t it be nice to have a comparison of DCA vs. lump-sum investing for the past 50+ years? We could compare investing $10,000 all at once in January of 19xx, versus using DCA equally over all 12 months of that year. Wouldn’t it be even nicer if we could take into account that any money not used be put in a high-yield interest bearing account?
Well MoneyChimp did just that all the way back to 1950. The result? I used 4.25% rate for bank interest, and over 60% of the time, lump-sum investing beat dollar cost averaging. This result of DCA losing out about 2/3rds of the time is supported by historical back-testing from 1926 in this article from the Financial Planning Association: ‘Lump Sum Beats Dollar-Cost Averaging’. (Just read the conclusion if you get bored.)
Of course, past performance does not guarantee future results. And DCA would smooth things out if your time frame is really short. I think everyone should consider the facts above and make their own decision. But I bet with the odds, and the odds are that I should invest it as a lump-sum.
However, if you don’t already have the money to max out your IRA, then by all means dollar-cost average!! In essence, you’re still getting your money in there as soon as your can.
By Jonathan Ping | Investing | 12/22/05, 4:59pm