The Wall Street Journal this week confirmed what investors feel in their gut: Stock market volatility is intense. Between September 21 and October 10, the Dow Jones Industrial Average moved more than 1% on 11 of 13 trading days, and five of those moves exceeded 2%, the Journal article said.
This creates a dilemma if you want to invest a large lump sum for the long term. What if you enter the market and it suddenly plunges?
To get around this problem, many financial advisors recommend dollar-cost averaging, or investing in stages. With this strategy, you get more shares of a stock when its price has dropped and fewer shares when its price has risen.
But there is a downside to dollar-cost averaging. If the market rises while you are “averaging in,” you miss out on potential gains. Those forgone gains could be substantial, because market rallies, especially coming out of bear markets, have often been very rapid, as we saw in 2009.
To quantify the trade-offs involved for US equities, we conducted a research study. We compared the strategies of investing all at once versus averaging in over 12 months, for every 12-month rolling period from 1926 through 2008.
To compare the effect of averaging in to a falling market versus a rising market, we also arrayed the 12-month periods by market performance, from the strongest to the weakest, in five quintiles. The bottom quintile included markets as bad as those of 2008, while the top quintile included markets like those of 1954, when the S&P 500 Index rose a whopping 53%.
We found that in poor markets (the bottom quintile), averaging in helped preserve capital, resulting in an average of 11.6% more wealth than investing all at once garnered. But in typical markets (the middle quintile), averaging in resulted in 2.9% less wealth and in strong markets (the top quintile), it resulted in 13.4% less than investing all at once (Display).
These results show that if you have a sum of money to invest for the long term, the odds are in your favor if you invest all at once. But playing the odds works best when you have multiple tries. If you have one chunk of money to invest today, dollar-cost averaging is a reasonable hedge against the risk of investing in a falling market—and the cost is about 2.9% of your potential gains.
If you do decide to average in, choose a systematic method and time frame and stick to them. Otherwise, emotions may sway your investment decisions, and that’s almost never a good thing.
The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AllianceBernstein portfolio management teams.
Daniel B. Eagan is the Head of the Wealth Management Group at Bernstein Global Wealth Management, a unit of AllianceBernstein.