In this month’s edition of “Money Matters,” Scott discusses dollar-cost averaging, explaining what it is, why it works, and the instances when it doesn’t work. Click the audio button to the right to listen, or read the transcript below.

Money Matters: Dollar Cost Averaging Transcript

0:00:00.1 CJ: WTIP is pleased to bring you another edition of Money Matters, a monthly feature intended to help us understand more about managing our finances. Scott Oeth is a certified financial planner and adjunct professor. He's taught retirement planning and wealth management strategies to hundreds of financial professionals, and he's joining us now by phone. Welcome, Scott.

0:00:21.5 Scott Oeth: Good morning, CJ.

0:00:23.0 CJ: Good morning to you. So, you said you thought it would be a good idea to talk about dollar-cost averaging. What is that?

0:00:31.6 SO: Yeah, it's an interesting and can be really useful strategy, and there's a couple of different ways that I think we should touch on different ways to look at it. But, putting on my standard disclaimer, anytime we're talking about investment topics, this is general information, seek your own advice, of course, on how it may apply to your situation. But, in short, dollar-cost averaging is the idea of systematically purchasing into the market at regular intervals. So, I'm going to put $100 into the investment market on the 15th of each month. Whether the market is up, whether the market is down, you've chosen your investment or your portfolio strategy and you're gonna just keep buying into it. There are a few different ways we can take a look at this for recurring small investments like that. A lot of people do retirement plan contributions through work. They fund their 401k or their 403b or maybe an IRA, and they just automate it like that. That's one way to take a look at it [Dollar Cost Averaging].

0:01:31.4 SO: Another way, and this is one that generates quite a bit of controversy and is hotly contested back and forth is, if you happen to have a larger chunk of money, maybe you've sold a vehicle or a home or received a small inheritance, or something along those lines, you have some pot of money and you're looking and saying, "The market looks kinda scary right now. Do I put this in all at once? Do I invest it, or should I dollar-cost average it into a market?" And then the third way is, think about on the opposite end, let's say you've accumulated funds and now you need income of your portfolio, should you essentially do a reverse dollar-cost average? So, touching on each of those, the first one, the accumulation phase, dollar-cost averaging can work very well. For a lot of folks, it works well and it's also what they have. They don't necessarily have a large amount of money at any one point in time, but those smaller consistent savings really add up over time. I've worked with many, many people over the years who've done really well over the course of their career by putting money into their retirement plans, putting money into their IRAs. And you look back, they can't identify any specific investment decision along the way. They weren't having to decide does the market look good, is this a great time to buy, is this a bad time? It was automating that habit-dollar cost averaging- and when market is going up, great. But very importantly, when things are kinda like they are right now, there's a lot of uncertainty, there's a lot of concerns, the market's scary, it might not feel like a good time to invest. Automating that habit lends a lot of power, and the money goes in, and what happens, this is kinda neat, is that when the market goes down, if you've chosen a high quality portfolio and investments, you're buying more shares. They may be at a lower price but you're buying more quantity, and you'd expect to benefit from that when the market eventually recovers, those shares re-inflate. It [dollar-cost averaging] can work very well in the accumulation side.

0:03:21.1 CJ: Okay. Well, it sounds like lots of people are automatically doing this dollar-cost averaging into their retirement accounts. But what about other situations or types of accounts, is dollar-cost averaging always a good way to invest?

0:03:35.6 SO: Yeah, and this is where it gets interesting, CJ. Maybe, or, not necessarily… There are a few more ways to look at it. With the small dollar amounts, I'm a big fan. It makes a lot of sense. I highly encourage it. Automate those investments, get those small amounts going in, you'll be surprised what it does for you over time. However, if you are in the happy situation where maybe you have a larger portion of money that's come from some source, say some type of asset, a gift, an inheritance, maybe you're rolling over your old retirement plan, you can be faced with what feels like a big decision and say, "Wow, this is more money than I've ever had at one time, or this is a significant amount. Do I invest it all now?" There is that fear that the market could go down, it could go down further, but there's the trade-off of missing returns on the upside. So you could dollar-cost average that. You could take that dollar amount, whatever it is, and you can divide it into portions and you can invest a certain amount each month, just like we talked about. There have been a lot of academic studies looking at this. In the Journal of Financial Planning back in 2004, took one of the most intense dives on this. They looked back over 65 years, and they found that even without accounting for dividends, you're typically better off to just put the money in as a lump sum, because the down periods in the market tend to be short, and the long ones tend to be much longer, and the overall trend historically has been upward and onward. So, if you can stomach it, if you can deal with a bit of risk, if you don't need any of that money in the near term, you're generally better off to choose a good portfolio, choose good investments, get some some help there, and put the money to work and buckle up your seatbelt and just get comfortable with the fact that you may see it fall in value 20% next month. That generally works, like 65% of the time is what the research shows you're better off investing when it is a lump sum. However, in real life, emotions are important, that's real money, and regret is painful so, that's not always what we do.

0:05:41.3 SO: It's okay to allow some emotions in there, and here again, a lot of it depends on people's individual, personal financial situations. But oftentimes we're looking and saying, "Well, maybe we come up with a hybrid strategy, maybe we invest half the dollars now and then dollar-cost average the rest in, or maybe we buy into what we'd expect to be less volatile or cheaper areas of the portfolio, areas that look more attractive, and then more cautiously work into the more volatile area." I think a hybrid strategy can be fine, and allowing for human emotions can be fine. You can look at it in paper and say, "Okay, historically 65% of the time, it would have been better off putting in a lump sum. But what about the rest of the time? I'm just not comfortable investing all of Uncle Joe's inheritance right now when it may go down significantly." So, it's not as clear when you're talking about a lump sum. And when you're taking money out, it really does become a different story.

0:06:40.0 CJ: So there's a difference between dollar-cost averaging money into investments versus withdrawing the funds?

0:06:46.9 SO: Yep, there really is. Setting up your plan in the beginning and then just automating, with dollars going into a portfolio we've said can work well on the upswing, when you're in that accumulation phase. You have a long period of time ahead of you, and the market volatility can actually work in your favor. When it has one of those fall backs in the market, you're buying at a lower average price, and in the long run, it typically works very well. But, on the other side, let's say you've reached retirement and you need to generate income off your portfolio, that can really work against you. We want to be careful, we encourage people to be careful about having to sell securities when they're at a low point. Ideally on the other side, we're trying to unwind things and generate income from a pool of assets. What we really want to be able to do there is be very selective about when we're selling things, and hopefully selling them at high points or at least attractive price points. There's even a term, reverse dollar-cost averaging, and it can lead to depleting the portfolio quicker than you want to, and really the name of the game in retirement income planning is generating an efficient and sustainable long-term portfolio withdrawals.

It can get pretty complex, CJ, there are a lot of different strategies, but I think two things are going to help a lot. First of all, ideally you have a very diverse, well-designed portfolio. So you have many different types of assets to choose to be able to draw from different points in time, and having a pool, a holding tank or what some people could say like a safety bucket of lower volatility liquid investments to be able to tap those during rocky market periods, and let the other assets sit so they can come back and then you sell them at attractive points in time.

0:08:39.3 CJ: Got it. Wow, that's a lot to take in. I'm sure you're gonna have more of the information about this on your blog, correct?

0:08:47.7 SO: Yeah, I've written quite a bit about, of course, dealing with volatile markets. A lot about generating retirement income streams, it's quite a bit there on the blog, and a lot more I'm sure we'll be talking on the future as well.

0:09:00.6 CJ: Indeed, indeed. We're talking with Scott Oeth, and we'll be talking finances with Scott on the first Wednesday of the month on North Shore Morning. Did we cover pretty much all of it, Scott? Is there anything left that you wanted to share?

0:09:12.8 SO: Well, I think we hit the high notes. There's quite a bit out there, I encourage people to seek their own advice. You can always shoot me a message, but I think we covered three important ways to look at this question of dollar-cost averaging.

0:09:23.1 CJ: Alright. Well, thank you so much for your time today, Scott. We'll check in again in a month.

0:09:26.9 SO: Thanks, CJ.