After a bunch of philosophical posts in a row, today’s post is more concrete: we’re talking investment strategy. But we also wouldn’t be us if we didn’t talk about the feelings wrapped up in all of it! All the usual caveats apply: we’re not financial advisors, none of this should be considered investment advice or legal counsel, your mileage may vary, etc. — you know the drill. ;-)
At tax refund time, just as at year-end bonus time, a lot of us are thinking about what to do with that chunk of cash we’re receiving. (Ahem — not us this year. We owe and are still dreading the day it comes out of our “life happens” fund.) In the past, we would have dropped that refund into a savings account we used for dollar cost averaging (DCA), and let it slowly get invested, twice every month, into our Vanguard index fund accounts, or going back further, into our USAA mutual funds.
Dollar Cost Averaging
For a long time, we were big fans of dollar cost averaging, the notion that you hedge against market losses by not buying a whole bunch of shares at one time, but rather in smaller increments over time. The idea is that you buy more shares when the price is low, and fewer shares when the price is higher, which intuitively makes sense as a good thing, so you don’t load up on expensive shares. And note that we’re not talking about making automated investments each month as paychecks roll in — that’s a very good thing. We’re talking about the real dollar cost averaging, which is assuming you have a chunk of cash available to use, but rather than investing it all at once, you break it into smaller investment amounts over time.
For naturally risk-averse people (me me me me me!!!), this is an incredibly appealing concept. Dollar cost averaging addresses the fear that the market will crash right after you invest your big chunk of money, eroding your value overnight. Instead, it gives you limited exposure to any given share price, which seems smart, right? There’s only one problem:
Mathematically, it turns out dollar cost averaging is not that great a strategy after all.
Vanguard did a now-famous study in 2012 that showed that, over time, dollar cost averaging leads to smaller investment gains than investing windfalls in single lump sums about two-thirds of the time. Why? Mainly one reason: While you may give yourself a hedge against precipitous market losses, you also lose the upside benefit of having time for that money to grow in the markets. As Vanguard puts it: you’re losing out on market exposure for some period of time with much of your money, which means you’re passing up potential gains in the interest of protecting against losses.
Essentially, dollar cost averaging is a fear-based investing strategy, focusing more on the fear of losses than the hope for gains. It’s not a great place for your head to be if you’re planning to be an investor over the long term, which is what you need to be if you want to succeed in the markets.
Changing Our Mindsets Around Risk
Before I could really embrace the notion of early retirement, in which we’ll live primarily off of our investments, I had to get comfortable with the idea of investing in the first place. On its face, it seems so risky. No FDIC guarantee and recent evidence that stocks can lose a lot of value overnight (hello 2008). You can totally laugh at me, but before I got my head right about this stuff, most of my “investments” were in things like intermediate-term bond funds, netting impressive amounts like 3 percent a year. I know, I know — you totally want my investment advice circa 2006.
I’m sure Mr. ONL must have wanted to bang his head against in the wall plenty of times trying to have this conversation with me in our early days:
Mr ONL: We need to invest our money so it will grow.
Me: But I’m afraid of losing value. I’d rather put our money somewhere safe.
Mr ONL: But “safe” investments actually mean we’re just losing spending power to inflation. We need to invest in funds that at least have a chance of outpacing inflation.
Me: Um, how about get me a blankie instead?
Sort of like the great FDR quote, “The only thing we have to fear is fear itself,” I sort of felt like anything we could do was too risky simply because risk exists. But what I failed to see was that literally any choice entails risk. It isn’t really a clear-cut choice between safe investments and risky ones (though there are certainly plenty of risky ones).
In truth, any savings account or investment option that felt safe to me came with a different kind of risk: inflationary risk. In other words, the risk that your spending power will decrease because the funds won’t gain enough value to keep pace with inflation. And frankly, with the sub-1% rates most savings accounts pay these days, that inflationary risk is more like an inflationary guarantee.
Related: Getting Comfortable with Risk
Coming to terms with inflationary risk changed everything for me, and made me accept that I needed to invest like a grown-up if I wanted to reach big goals. The notion that there was risk everywhere, and not this black-and-white world of “safe” versus “risky,” was actually very freeing. Because instead of being scared of investments where we could lose value, I could now evaluate upside and downside risk alongside the same metrics for other possible investments. And I really started to see that holding a lot of cash in low-interest savings account was actually pretty risky, too. I did not want a guarantee that we were losing spending power every single month — I wanted the chance for our assets to grow, not the guarantee that they would shrink.
Applying the Same Thinking to Dollar Cost Averaging
Dollar cost averaging is kind of like investing with a security blanket. It feels comfortable and safe, but it was actually holding us back from seeing all the gains that we could see, and which would supercharge our retirement savings. Because, as we’ve seen, even tiny differences in gain percentages, over the long term, can make enormous differences in what our assets total.
We took that Vanguard study seriously when we learned about it, along with a similar one done by AllianceBernstein in 2014. Both helped us see that the perceived safety of dollar cost averaging was an illusion, and in most cases, we’d be losing potential gains that way. And on the topic of risk, as Vanguard puts it, dollar cost averaging is just punting that risk until later. Because there’s no escaping risk in this game, there’s just a question of when to face it, and whether you’re comfortable giving up gains in the meantime. For us, that begged the question: If the risk is always going to be there, why would we keep giving up possible gains?
A Marketing Tool to Get Risk-Averse People to Invest
Plenty of people will still tell you that dollar cost averaging is a smart investment strategy, even after the Vanguard study proved the math. Like this NASDAQ story from 2014. Or this WSJ story that acknowledges that dollar cost averaging results in decreased gains but still recommends it. Most of the people pushing dollar cost averaging are those who want more people to invest, preferably with their institution. So rather than break down the math for you, they give out the security blanket in hopes of luring more people in.
If you’re terrified of investing in stocks and bonds because you’re afraid of losing all of your money, then dollar cost averaging might be a good strategy for the short term, as you get comfortable with watching your share prices go up and down. It’s for sure nerve-wracking at first if you’re in the risk averse camp, and giving yourself an intro period of averaging in to smooth out the big peaks and valleys could make total sense. But once you’re used to that, it’s worth asking if that strategy still makes sense for you long term. Just like all financial advice, it’s important to take everything you read with a grain of salt, and ask yourself if the person giving the advice has anything to gain by you lsitening to them.
What We Do Now
Our big financial decision period is always the end of each year, when we’re deciding what to do with our year-end bonuses. We typically have a comparatively large windfall then, and have to decide how much to put against the mortgage, how much to invest and how much to spend on something frivolous, like new (used) skis. For years, we’d take whatever amount we allocated to investments, and rather than invest it all in a lump sum, we’d put it into a “high-interest” savings account, and set up automatic transfers twice per month from that account into our investment account, taking as much as a year to invest the prior year’s bonuses.
It felt safe. It felt comfortable. But then we learned: it probably also cost us money in the form of lost gains.
Now, when we get a windfall, we invest it all at once. And I’m not gonna lie: It is a tougher approach for that part of me that still hates risk. We socked a big chunk into our investments at the end of last year, and then watched as all of our accounts immediately went down in January and February of this year. Thankfully we’re now back up on all of that stuff, but it was a good lesson that I need to get used to a different kind of ride with our new lump sum investing (LSI) approach. Regardless, we’ve assessed the risk of this approach, and we’re comfortable with it, so we’re going to ride it out. And because we still invest a big chunk of our paychecks every single month, regardless of what the market is doing, we’re also getting the benefit of the theory of dollar cost averaging, but without having to miss out on gains for money that’s just cooling its heels in the bank.
What Works for You?
Anybody else gone from being a dollar cost averaging investor to socking away lump sums instead, like we did? Or want to make a strong pitch for why dollar cost averaging is the best strategy for you? Any success stories of how dollar cost averaging got you comfortable with investing in the first place? We’d love to hear from everyone in the comments!