Dollar-cost averaging has long been a tried-and-true method of introducing wary investors to the stock market and the concept of forced savings. One of its key attractions is it reduces risk. Holding, on average, half a portfolio in cash for the year is clearly a more conservative route.

But what about the nervous client with a significant amount of cash — say, from the sale of a business, an inheritance or a bonus — who is not sure what to do next?
Some will want to wait to enter the market until stocks fall to a certain level; others will wait for a market rally, hoping to ride the wave.

A group of researchers at Bernstein Investment Research and Management examined what would have happened if a portfolio that was 60% stocks and 40% bonds had been invested beginning on the first day of each of the worst bear markets since the Second World War — in other words, the worst possible timing. They compared returns generated by dollar-cost averaging over the next 12 months using the following formula: investing one-fifth at the beginning of the first month, one-quarter of the remainder at the end of the third month, one-third of the remainder at the end of the sixth month, one-half of the remainder at the end of the ninth month and the balance at the end of the year.

Delaying entry into the market is valuable when the market is down, but costly when it is up — and the market has appreciated most of the time. In the past 60 years, there have been 691 rolling 12-month periods (January through December, then February through January, and so on) and the market gained in 77% of them. Further, large gains were far more likely than large losses. While the market went up 20% or more over a third of the time, it went down by the same amount only a small fraction of the time.

The distribution of returns for a DCA strategy was fairly narrow, clustered around a median return of 7.8%, Bernstein reports.
Returns for immediate investment were spread over a wider range, but the median was a striking three percentage points higher, at 10.7%.

In years of market decline, the DCA portfolio was insulated because the portion earmarked for equities was not fully invested; however, in market gain times, the portfolio couldn’t fully participate.

Reflecting the historical tendency of the
market to rise, the gains outnumber the losses in both frequency and magnitude, Bernstein notes. So investors must recognize there are trade-offs to be made, and must gauge how much money they can risk leaving on the table versus how much they can stand to lose.

If they choose a DCA program, there may be benefits to starting in certain months of the year, says Robert Atra, chair of the finance department at Lewis University in Illinois.
His research shows DCA investing seems most effective when implemented from February to September, and less effective when started from October to January.

DCA can be a lukewarm solution for cautious investors but a combination of the two approaches is best. Apart from the psychological advantage, DCA doesn’t reduce risk sufficiently. Replacing a major investment decision with many smaller ones doesn’t make the outcome safer or provide better return.

If clients’ biggest fear is a loss in the initial investment period, dollar-cost averaging may be the appropriate strategy. It’s certainly better than sitting on the sidelines, and compromises little in normal markets. If the big fear is a long bear market, the priority may be to readjust the asset mix strategy to ensure the right balance between capital preservation and growth.

Bernstein says it’s important to help clients understand the consequences of their decisions, so their emotions inform them but don’t dictate their actions. IE