The Case for Dollar-Cost Averaging

More than 20 years ago, I began to write Index Mutual Funds: Profiting From an Investment Revolution (Namborn, 1998). As far as I know, this was the first book (or among the first) to be published extolling the virtues of passive investment strategies. With a foreword by Jack Bogle, it foretold the prodigious rise of index mutual funds.

My other book, The Prudent Investor Act: A Guide to Understanding (Namborn, 2002), followed. It was written to set forth the legal and academic case for the use of index funds and other forms of passive investing. In 23 pages, the 1994 Uniform Prudent Investor Act and its supporting commentary draws upon and codifies the essential principles of prudence laid down by the 300-plus page 1992 Restatement (Third) of Trusts (Restatement). Together, the Restatement and the UPIA define the standards of modern prudent fiduciary investing.

The Restatement--the academically oriented and legally influential antecedent of the UPIA--clearly shows that, in a given situation, investment fiduciaries ordinarily should favor an appropriately prudent passive investment strategy. That strategy may be departed from--not implemented--but only if the extra costs and risks of an active investment strategy relevant to the situation can be justified by "realistically evaluated" return expectations.

This has helped form my view that the "default standard" of modern prudent fiduciary investing is passive investing. (This assumes, of course, that the passive investment strategy in question is reasonably low cost and low risk and, for taxable investors, low tax. There are, for example, index mutual funds that are quite costly and others that don't manage taxes very well and, so should be rejected as imprudent investments even though they are passive ones.) To date, I don't believe that any court has applied this analysis in a case--perhaps because it has never been asked to do so.

Sometimes the findings or views on subjects covered in books written some time ago do change. For example, back in the days when I was doing research for my two books, the academic literature was pretty consistent in finding that dollar-cost averaging was superior to lump sum investing. Today, however, it appears that the opposite conclusion is the favored one.

I still believe that dollar-cost averaging is the better course to follow, though. That's because of the overriding importance of prudent diversification of portfolio risk. Many investors confidently state that at present, the market is "high." Well, yes, historically, it is high. But in a month or six months or a year, we may come to find that today's high is actually pretty low should financial markets advance sharply.

Or those markets could go in the opposite direction, or they could languish somewhere in the middle for some indeterminate period of time. The point is that we just don't know what the future holds in store for us as investors, nor do we have any way of knowing given our present vantage. We cannot tell now if the market is high or low, relative to the future. When it comes to investing we are all awash in a vast sea of uncertainty. And that's why prudent investors ordinarily should dollar-cost average.

The following passage appearing in a recent article helps explain my view of dollar cost averaging within the context of prudent investing:

"Investing is ultimately an exercise in regret minimization. Investors need to ask themselves what they would regret more--missing out on further gains in the market or taking part in large losses? Investing all of your cash at once gives you a higher probability of taking part in larger gains but also taking part in larger losses. To decrease market risk and sleep better at night, dollar cost averaging in a higher valuation environment can lead to a smoother ride and give a lower probability of seeing large losses."

By the way, this is how the father of modern portfolio theory thinks about his own personal portfolio. Nobel laureate Harry Markowitz holds a 50/50 portfolio because he wants to minimize his future investment regret. He knows, as the behavioral economists tell us, that his bad feelings when he suffers market losses will be more intense (and thus make him more prone to flee financial markets--selling low--and more prone to wait a long time before reentering subsequently rising markets--buying high) than his good feelings will be when he experiences market gains. These economists contend that, as humans, that's just how we--including at least one Nobel laureate--are hard wired.

Dollar-cost averaging is an additional layer of diversification. Like diversification of a portfolio's investments, we should diversify monetary contributions to our portfolio through dollar-cost averaging because we do not and cannot know what will happen in the future. This view also has the merit of dovetailing with one of the primary tenets of the Employee Retirement Income Security Act of 1974: diversification of large losses. ERISA Section 404(a)(1)(C) states, in part: "… [A] fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries … by diversifying the investments of the plan so as to minimize the risk of large losses …"

My April and May columns maintained that minimizing large losses by broadly and deeply diversifying portfolio risk is mathematically more important than attempting to maximize gains as stock-pickers, market-timers, and track-record investors are wont to do. (Yes, yes--there are those that reign as masters of the universe but, as shown by mountains of academic studies over the last half century, the membership in that club constantly changes unpredictably and the winners, by definition, can be known only after the race is run; the inescapable fact is that no one knows who the winners will be before it is run.)

An investment strategy based on this approach is also easier when it maintains a focus on the primacy of the portfolio; after all, Markowitz is the father of modern portfolio theory, not modern investment theory. In addition, the approach ordinarily is legally required of fiduciaries by various bodies of fiduciary investment law including ERISA and the UPIA. This approach is also psychologically relatively easier on investors, not to mention their advisors.

Many advisors and their clients may think a reasonably low-cost investment strategy that's mathematically rigorous in reducing portfolio risk, legally sound, academically robust, and psychologically easier on investors and their advisors to be rather boring. That may be but it's also a very powerful way of investing, especially for fiduciaries responsible for money not their own.

To me, the fundamental, underlying goal of an investment portfolio should be to minimize risk (the frequency and magnitude of portfolio losses) by means of broad and deep diversification (while incurring no more than reasonably low costs) in order to help earn the greatest return possible allowed by the financial markets in which the portfolio's asset classes are invested.

Access Scott's previous articles here. W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. For more information, visit Prudent Investor Advisors, or email ssimon@prudentllc.com. The views expressed in this article do not necessarily reflect the views of Morningstar.