We often speak of reducing your investment risk through diversification, or in other words: having your eggs in many baskets. Investing in different asset classes such as bonds, stock, funds, property, commodities and alternative investments. Diversifying across different geographic regions and currencies provides another element of diversification as well. This can be visualized as spreading risk vertically by stacking up and buying different types of assets. A way to diversify horizontally as the market moves through time, and likely one of the most effective tools in personal finance, is spreading your risk across time through dollar cost averaging.
Investor Mistakes: Timing the Market
Timing the market can be a tricky thing indeed. “Buy-low, sell-high” certainly falls into the category of things “easier said than done”, as very few have been able to successfully execute this maneuver with any regularity or consistency. Rather than becoming the next budding day-trader, the intelligent long term investor is better off taking the position not of trying to buy-low, sell-high; but instead simply accumulating assets of value over time. If you are saving for a long period of time, whether it be for the goal of financial freedom or perhaps a children’s education fund; it is best to mentally position yourself as simply a net-buyer of assets for the next couple of decades.
The question is, at what price are you buying those assets? As it is a near impossibility to consistently predict market downturns or recognize the precise moment before it turns around and goes back up, this would indicate that attempts made to time the market would likely be in error. More often than not, an investor would likely fall prey to emotional investing, missing out on opportunities and making other tactical blunders with regard to risk management and proper asset allocation. It would then follow that rather than trying to time the market, it would instead be better to adopt a steady asset accumulation strategy that regularly purchases your investments on a pre-determined basis. In congruence with a well diversified portfolio, this strategy will ensure that you accumulate your fair share of the total market returns over the relevant period of time. Buying in to the market 12 times per year does not guarantee you will get the absolute best prices for the assets you purchase; but nor will you be caught paying the absolute worst price; instead your average purchase price will tend to swing towards the middle. In fact, during periods of market volatility, dollar cost averaging can even work out in your favor.
Dollar Cost Averaging Example
More than one academic study over the preceding decades has looked into dollar cost averaging and its actual effectiveness. A more recent report conducted by Vanguard in fact determined that approximately 2/3 of the time, an investor actually would have been better off investing a lump sum each year rather than splitting it up into small monthly investments. The study simulated over 1,000 different scenarios in the market over the last almost 100 years. However, this should come as no surprise, that an investment fund company’s funded research comes to the conclusion that you should give them all your money all at once rather than spreading it out over time. It does however seem to pass the sniff test. Markets do go up in the long run, so that would imply that at least more than half the time any lump sum investment should end up a winner even in the short term, and in theory any delay to allocate capital would just be opportunity cost.
This study does, however, contain significant assumptions that would derail or invalidate their conclusions if altered. Firstly, it assumes that you as investor have all the necessary funds to make a capital investment at the beginning of the year. In other words: you have $12,000 to invest all at once rather than putting away $1,000 per month. Some people may just be getting started with their savings, and do not yet have the lump sum accumulated. Waiting until the end of the year each year to invest then exposes them to opportunity cost, meaning the missed opportunities for gains if the market goes up during the year and their cash was still sitting in the bank. While seemingly small, it can add up to substantial missed opportunities over time. It also assumes no impact of behavioral and cognitive biases on one’s financial decisions. Unfortunately these are quite difficult to escape, to the detriment of our long term investment returns. Dollar cost averaging at the very least helps to limit this negative impact.
Or, take another example whereby perhaps they do have a small lump sum, but investing it all at once would wipe out their emergency fund. This comes highly un-recommended; as it would violate one of the most fundamental risk management practices of always keeping sufficient liquid capital in reserves. Lastly, and though slightly more difficult to accurately quantify, is the issue of behavioral finance. Plans to accumulate a lump sum to then invest at the end of the year do not always pan out. Unforeseen expenses come up, “just have to take care of this, just this year” events happen, and year-long savings targets fall short of expectations. A computer simulation concluding that a certain strategy wins slightly more on average if given 1,000+ scenarios likely does not also account for an investor’s actual savings at the end of the year being 75% or 50% of their target. Committing to monthly investing, “paying yourself first”, splitting your accounts into short, medium, and long-term savings; there is a reason these fundamental principles of personal finance have lasted for so long; because they work, and attempts to re-invent the wheel tend to fall apart. Save and invest consistently and after a number of years you will be able look back at what you have achieved, not by genius, but by discipline