Dollar Cost Averaging: Irrational But Smart
Dollar-cost averaging is routinely advocated by stock brokers, financial columnists and others as the best way to invest over the long term. These experts argue that investors should buy a fixed sum, say $100, each month of stocks, bonds, mutual funds or other investments rather than buying securities in one lump sum. By buying over time, investors will lower the average cost of the securities they are purchasing and reduce risk compared to the person who buys shares all at once and exposes herself to a big tumble tomorrow. Seems logical but it's wrong. Many studies have shown that dollar-cost averaging doesn't result in higher returns or lower risk, not least of all because stocks rise in value over time and investors will be buying at average, higher prices the longer they wait.
While dollar-cost averaging doesn't make sense from a dollars and cents point of view, it does from a psychological point of view.
Investing is a tough psychological act and many people are afraid they may blow their retirement, college fund for junior or other investment pool if they make the wrong decision and regret it for the rest of their lives.
How to fight that lousy feeling? Create psychological barriers, according to Meir Statman, a professor of finance at Santa Clara University.
Actions taken under duress entail little responsibility and bring little regret, Statman wrote in a recent study. The ability of a dollar-cost averaging plan to reduce responsibility is especially helpful for investors who are concerned about their exposure to regret.
Another psychological problem that dollar-cost averaging overcomes is our lack of self-control. We are simply too emotionally involved with our investments to shake off news about the market, whether it's bullish or bearish.
Investors who practice dollar-cost averaging are more likely than other investors to continue buying stocks after a period of declines in stock prices and less likely to accelerate buying after a period of increases in stock prices, Statman found.
Bottom line: it would be great if humans were like computers when it comes to investing. Unfortunately, that's not the case. Most investors, even highly sophisticated money managers, are all too prone to making decisions based on short-term stock price movements and psychological fears. Dollar-cost averaging, while not improving our returns in terms of investment theory, is a way of helping us build and maintain a profitable nest egg.
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