Suze Orman’s favourite investing method may cost you money

The case for dollar-cost averaging

Orman, a best-selling author and TV personality, says dollar-cost averaging “puts time, your money and the market on your side.”

You might already be using DCA with an RRSP, setting aside money on pay day to put into this account. And some popular investing apps allow people to use the same approach by setting up automatic deposits.

Say you decide to invest $100 per month into Gap (TSX:GPS) stock. Today, that might buy four shares — but with DCA, you don’t make decisions based on how many shares you’re getting.

If the price crashes by 50% next month, that $100 can now buy eight shares. Sounds like a bargain! And if the price doubles instead? To offset the risk of buying too high, you’re now making a conservative purchase of only two shares.

“In times where the markets are very confusing and they're going up and down ... if you dollar-cost average and the markets go down and eventually the markets start to come back up again, you will make more money, most likely, than if you invested in one lump sum,” Orman said on her Woman & Moneypodcast .

A new study, however, says it doesn’t usually work out this way.

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Dollar cost averaging is not an effective investing strategy

Though dollar-cost averaging is appealing due to its simplicity, numerous studies have shown that it is not the most effective strategy.

In a 2020 study, the Globe and Mail compared the performance of lump-sum investing with dollar-cost averaging over a period of 12 months across six different stock markets. During this period, the cash being invested earned the rate of one-month US Treasury Bills, a stable asset with relatively low expected returns, making it similar to cash.

The results of this study indicated that investing in a lump sum outperformed dollar-cost averaging in approximately 65% of the cases across the different markets sampled. On average, the annualized cost of dollar-cost averaging was about 0.38% higher than lump-sum investing over 10 years.

The study explored the effectiveness of dollar-cost averaging in the most unfavourable 10% of outcomes for lump-sum investments. The goal was to determine if dollar-cost averaging could be beneficial in situations where lump-sum investments did not yield positive results.

In this subset, dollar-cost averaging demonstrated a minor advantage on average, yet it still fell behind lump-sum investments in just over half of the periods. It's important to note that these are the worst periods for lump-sum investments. Therefore, even if you could predict that it was an unfavourable time to invest a lump sum – a prediction which is, realistically, impossible to make – there is no guarantee that dollar-cost averaging would yield a better result.

What should investors do instead?

While history seems to support one investing style, the choice between lump sum and DCA isn’t an obvious one.

“Considering only historical data when making this investing decision ignores the behavioural and emotional side of investing,” says Matt Wilbur, senior director of advisory investments at Northwestern Mutual in the US.

If the fear of investing a lot of money at once is keeping you from investing at all, you might benefit from the slow and steady method. DCA also beats holding on to your cash while you wait for a “good time” to invest, the study says.

And despite Orman’s passion for dollar-cost averaging — she even has a DCA calculator on her website — the financial guru acknowledges she would have recommended going all in back in 2007 and 2008, when the markets were crashing.

“But we're in uncertain times right now. So, if you don't know what to do, this is a way for you to invest, and in the long run, probably come out further ahead, especially if the markets are volatile,” she says on her podcast.

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Put your strategy into action

Keep in mind, the decision about whether to use lump sum investing or DCA only applies if you actually have a lump sum to invest.

If you do, make sure to spread your big investment around to minimize risk. Check out one of today’s popular robo-advisors if you’re not sure how to craft a well-balanced, diversified portfolio.

If you prefer the advantages of dollar-cost averaging, or you don’t have a lot of money to spare right now, plenty of investment apps allow you to automate small, regular investments.

Some of these apps offer “fractional trading,” which allows you to buy portions of expensive shares like Apple (TSX:AAPL) or Tesla (TSX:TSLA), no matter how small your monthly deposit is.

Another option is to choose an app that invests your “spare change,” rounding up day-to-day purchases to the nearest dollar and investing the difference.

Sources

1. SuzeOrman.com: Making the impossible possible (Oct 4, 2020)

2. Globe and Mail: Why lump sum investing beats dollar cost averaging (Jan 18, 2024)