The field of behavioral finance tells us that our fear of financial loss exceeds our desire for gain. This observation helps explain why most of us, given a sum of money to invest, prefer to enter the market in stages rather than all at once.

On the basis of the historical record, however, investing all at once is the better choice more often than not. During the last 80 years,¹ the U.S. stock market has gone up more than 70 percent of the time; so, the odds that the market will outperform cash are in our favor. By being fully invested from the start, we can enjoy all the potential gains.

But investing this way may be unnerving, especially after a year like 2008. The memory of painful losses is still fresh, stock market volatility remains high, and the economic future looks bleak. What if the market plunges again and our stake is abruptly diminished? Fearing this possibility, many of us hedge our bets and choose to enter the market slowly.

In fact, the practice of staged entry has been codified in a strategy known as dollar cost averaging, whereby one systematically invests a fixed amount of money in the market at regular intervals. In this way, one gets more shares of a stock when its price drops and fewer shares when its price rises.

But there is a downside to dollar cost averaging: If the market rises while we are “averaging in,” we miss out on potential gains. And those forgone gains could be substantial. Market rallies, especially coming out of bear markets, have often been rapid, with the bulk of gains occurring within a short time. Missing such gains could have a substantial impact on our wealth if we are investing for the long term.
How great an impact? Suppose you come into a windfall from a liquidity event, such as an inheritance or the sale of a business. Should you hold it in cash and “average in” to the market, or should you invest it in one lump sum?

To quantify the trade-offs involved, we compared the strategies in a historical analysis of the U.S. stock market since 1926, the point at which reliable data begin. This period encompasses about 1,000 different entry points across a wide range of market environments, from the Great Depression to the raging bull markets of the 1980s and 1990s to the worst of 2008.²

The results of our research provide practical guidelines for investors who are considering a move into the stock market. We found that investing all at once tends to produce more wealth over time. But for nervous investors, dollar cost averaging is a reasonable “insurance policy” against market risk — provided you don’t overpay.

The Facts
Statistically speaking, investing all at once has been the best strategy for maximizing returns. The average gain of the stock market in all the rolling 12-month periods since 1926 was 12 percent. During the same periods, the average result of sitting on cash was only 4 percent. And, not surprisingly, the strategy of dollar cost averaging came in at the middle: 8 percent. (See Display 1)

The market’s performance before each 12-month period had only a slight effect on this pattern. In fact, because of the stock market’s tendency to revert to its mean growth rate, the odds for a strong 12-month period improve if the market has lost ground in the previous 12 months.

Regardless of how one entered the stock market, the average one-year returns were much better in years following a negative 12-month period than in years following a positive 12-month period. The strategy of investing all at once generated average returns of 11 percent after a positive year but 15 percent after a negative year. And dollar cost averaging chalked up average returns of 8 percent after a positive year but 10 percent after a negative year. (See Display 2)

Holding cash — that is, not investing — did not come close to the returns of the stock market in either case but was especially detrimental to returns after a negative year. Remaining in cash yielded only 3 percent in the periods following a down year, 12 percentage points less than the yield from being fully invested. This finding reflects the fact that when the stock market recovers from a losing streak, it can rebound quickly.

But just because the statistics favor investing immediately doesn’t make it the best strategy for all investors. A trade-off exists between the potential reward of stock market gains and the risk that the market might drop after you’ve invested. And everyone has a different tolerance for risk. So, we developed a framework to help evaluate the trade-offs.

Calculating the Costs and Benefits
Once again, we analyzed stock market data for each 12-month rolling period since 1926. We compared the total wealth resulting from a strategy of investing all at once with the total wealth from a strategy of averaging in over 12 months. We also ranked the 12-month periods by market performance, from the strongest to the weakest, in five quintiles. The bottom quintile included markets as bad as those of 2008; the top quintile included markets like those of 1954, when the S&P 500 rose 53 percent.

We found that in poor markets (the bottom quintile of performance), averaging in helped preserve capital and resulted in an average of 11.6 percent more wealth than investing all at once. In typical markets (the middle quintile of performance), averaging in resulted in 2.9 percent less wealth. But in strong markets (the top quintile of performance), dollar cost averaging detracted significantly from returns: After one year, the average wealth was 13.4 percent less than the average wealth from investing all at once. (See Display 3)

Note that these results are asymmetrical. The benefit in poor markets is less than the cost in strong markets. Moreover, this cost has an enduring impact on an investor’s long-term wealth: At the end of one year, both strategies will be fully invested, but the portfolio that used dollar cost averaging is more likely to be starting in a hole.

Of course, dollar cost averaging also has a nonmonetary value: It can help a nervous investor sleep at night. So, a logical way to think of the strategy is as an insurance policy against stock market loss. The policy has a cost — in typical markets, it is 2.9 percent of one’s holdings — and so you should ask whether that price suits you.

Timing
Let’s say that you’re willing to pay the price of averaging in to the stock market. The next question is whether an optimal period for doing so exists.

We examined the cost and benefit of averaging in over different time periods, from six months to two years. We measured the cost as the amount of potential gain lost by averaging in during typical markets; we measured the benefit as the amount protected by averaging in during poor markets.

We found that, to a certain extent, the longer you take to average in, the higher the cost and the greater the potential benefit. (In effect, you are buying more insurance.) But if you extend the strategy too long, the benefit doesn’t keep pace with the cost. Between zero and six months, there is roughly 7 percent protection for a cost of about 1 percent. Between 6 and 18 months, the trade-off between cost and benefit moderates; after 18 months, there is little increased benefit for a much higher cost. (See Display 4)

We conclude that averaging in for six months or less offers the best trade-off between cost and benefit. But for risk-averse investors who are willing to effectively pay an increased premium, one can extend the strategy as long as 18 months. Beyond 18 months, averaging in doesn’t make financial sense (unless it’s part of a program like payroll deduction, where the money becomes available only over time).

Find Your Right Balance
Our research shows that if you have a sum of money to invest for the long term, entering the market all at once will usually prove to be a better strategy than dollar cost averaging. The odds that you will reap greater wealth in the end are in your favor. But dollar cost averaging is reasonable insurance against the risk of investing in a falling market.

If you decide to average in, however, you must choose a systematic method and time frame and stick to them. The alternative invites emotions to rule your investment decisions, which most likely will erode your wealth over the long term.

Gregory D. Singer is director of research and Ted Mann is an analyst in the New York office of the Wealth Management Group at Bernstein Global Wealth management.