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Dollar-Cost Average or Invest In One Lump Sum (or Pay Down Debt)?

With the bond universe ranging from " ... obscenely overpriced to somewhere on the expensive side of fair value", and with most major U.S. stock indices within shouting distance of all-time highs, the current market environment is presenting a quandary not just to financial advisors but to investors as well.  The investing public with cash on the sidelines seem torn between the fear of missing out on a further rally in stocks and the fear of committing capital at valuations that have often presaged middling returns, if not nasty bear
markets.  Consequently, a question clients have been posing recently is: Is it better to commit new money to
the markets as fast as possible, or is it better to dollar-cost average our way into the markets over time?

It shouldn't come as any surprise that various academic studies have focused on answering this question. It may, however, come as a surprise, in light of the purported benefits of dollar-cost averaging, that most of the evidence has come down on the side of committing lump sums to the markets.  As an example, to see Vanguard's research on dollar-cost averaging, please click on "Dollar-Cost Averaging Just Means Taking Risk Later"

The reason for this result is fairly simple.  All of these studies rely on historical data, i.e. the research focuses on how an investor would have done historically if she had invested a lump sum all at once compared to if she had invested the same amount periodically over the course of months or quarters.

Since historical returns on all asset classes have been positive over long time periods, it's almost a mathematical certainty that this type of study will conclude that investing more as soon as possible is better. Waiting to invest will usually cost you money if the investment in question generally yields positive returns.

In this market environment, however, I think a more interesting question, at least for some investors, is not "How should I commit additional capital to the markets?", but rather "Should I commit additional capital to the markets?"

Certainly if your alternative to investing is to sit in cash, and if your investment time horizon is intermediate- to long-term, I would argue the odds still favor investing, even at these prices, considering cash is almost sure to lose purchasing power to inflation.  But what if the alternative to investing at these levels is to pay down debt?

Ultimately, your ability to successfully fund your financial objectives will be more dependent on your net worth than on the size of your portfolio.  And there are 2 ways to increase your net worth - either grow your assets or shrink your liabilities.  With stock, and especially bond, valuations where they are, the option
to pay down debt instead of, or in addition to, investing becomes more compelling.

About the Author

Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.  

Contact Paul