Personal finance writers often extol the virtues of dollar-cost averaging, which involves investing consistent dollar amounts over time instead of all at once, as a way of improving investment outcomes. But the notion that dollar-cost averaging improves returns has been thoroughly debunked. The reason is simple: If returns are generally positive, you're better off having more dollars working for you instead of holding them back to invest over time. Statistically speaking, the market goes up more often than it goes down, so keeping money off to the side usually doesn't help.

A Vanguard study published in 2012 looked at returns for a portfolio combining 60 per cent stocks and 40 per cent bonds over rolling 10-year periods from 1926 to 2011 and found that dollar-cost averaging led to better returns only about one third of the time. Morningstar conducted a similar study in 2019, testing an equity-only portfolio over time periods ranging from two to 120 months, also going back to 1926. In our study, dollar-cost averaging improved returns for the equity-only portfolio in 27.8 per cent of the 10-month periods but only 10.0 per cent of the 10-year periods tested.

Dollar-cost averaging typically fares best in periods with negative total returns. In the technology correction from March 2000 through October 2002, for example, dollar-cost averaging into an all-equity portfolio with no starting balance would have limited losses to 1.75 per cent, compared with an annualised loss of 13.84 per cent for lump-sum investors.

In periods with positive total returns, on the other hand, dollar-cost averaging usually leads to weaker results. Even in 2020's volatile market, investors who invested the same dollar amount every month in an all-equity portfolio with no starting balance would have earned an internal rate of return of just 3.4 per cent through the end of August, compared with about 9.7 per cent for the buy-and-hold approach.

Diving into the gaps

We also looked at the effect of dollar-cost averaging in our annual Mind the Gap study, which estimates investors' actual returns after accounting for the effect of cash inflows and outflows. The study focuses on comparing investor returns (also known as dollar-weighted returns or internal rates of return) with time-weighted total returns to see how large the gap, or difference, has been over time. For the first time, we added a series of returns based on a hypothetical scenario in which an investor contributed equal monthly investments to funds in each broad category group. We then compared the dollar-cost averaging results [1] to the actual investor returns as well as reported total returns.

Not surprisingly, the dollar-cost averaging results were lower than reported total returns in nearly every major category group. As mentioned above, that's to be expected given that annualised returns were generally positive for the 10-year period covered in the study. The only exception was alternative funds, which would have fared better in a dollar-cost averaging scenario thanks to their negative returns.

But in certain areas, following a more systematic investment approach would have led to better results, albeit not as good as simply investing a lump sum for the entire period. With sector funds, in particular, the returns in the dollar-cost averaging scenario were about 1.3 percentage points per year better than investors' actual results. These funds are particularly prone to performance-chasing, with investors often piling into popular sectors after they've already posted strong returns and then bailing out when they fall out of favour. Following a more disciplined approach would have helped investors avoid some of the pitfalls of these funds.

Dollar-cost averaging would have also improved returns for international-equity funds, by about 0.9 percentage points per year. Cash flows for these funds haven't been too volatile, but there have been some missteps, such as when strong asset flows in 2013 were followed by negative returns in 2014. As a result, dollar-weighted returns have lagged total returns by about 1 percentage point per year, on average, for the 10-year period ended 31 December 2019.

Other reasons for dollar-cost averaging

There are a few other times when dollar-cost averaging can make sense. The most obvious one is when you don't have a lump sum available to invest and instead put money to work as it becomes available. Most retirement-plan participants, for example, will set aside a percentage of each paycheck to contribute to their retirement plans over the course of each year. Purists wouldn't consider this dollar-cost averaging, but it has a similar effect, as it involves investing smaller amounts of money over time. As mentioned above, this method of investing will generally lead to lower investor returns during positive markets, but it's an essential way to build wealth and plan for a secure retirement.

Dollar-cost averaging can also be a reasonable way to handle a sudden inheritance or other windfall. Estate planners often counsel clients not to make any sudden decisions after the death of a spouse or other loved one, and it's perfectly reasonable to take a more gradual approach if you're overwhelmed by grief or having trouble deciding how to invest. Eventually, you'll want to come up with an asset-allocation target and invest your assets accordingly, but there's no need to do everything at once. That's especially true if you're worried about getting hit by a market downturn right after putting a large sum of money to work.

Similarly, taking a more gradual approach to rebalancing is a reasonable fallback if your portfolio is too heavy on cash or fixed-income securities but you're too nervous to boost your equity allocation all at once. Market history would tell us that delaying any shift toward your target equity allocation is more likely to lead to lower returns. However, if dipping a few toes in the water at a time is the only way you can ease yourself back into the pool, it's better than just sitting on dry land forever.

From a purely quantitative perspective, dollar-cost averaging usually doesn't maximise returns. In areas that are prone to volatile and poorly timed cash flows, though, it can lead to better outcomes over time. Taking a more systematic approach can also be a way to manage behavioural barriers that can get in the way of meeting your goals.

[1] While our investor return analysis is based on asset-weighted data, the dollar-cost averaging analysis is based on equally weighted data.