Dollar cost averaging

When you are ready to invest money, a common question is whether you should invest it as a lump sum or Dollar Cost Average (DCA) by splitting your investment across several payments. The answer depends on your psychology.

In most cases, you are moving your money from cash (or the equivalent, a low-yielding money market) to some mix of  stocks and  bonds. The expected value of both stocks and bonds are higher than cash. However, their volatility is higher as well. The risk is that just after making your investment, the market could crash, causing you to feel bad that you invested when you did.

Of course, according to Bogleheads Investment Philosophy, you should only be investing in the first place into a diversified asset allocation. Also, you should only be holding volatile funds like stocks and bonds if your investing horizon is long enough to ride out their volatility.

For a completely rational investor, lump sum investing will always produce a higher expected return, because it immediately moves your funds from asset classes with lower expected returns to ones with higher expected returns. Note that higher expected returns do not guarantee that your actual returns will be higher.

Some investor's have the goal, not of maximizing their expected returns, but of minimizing their potential regret. For those investors, dollar cost averaging is superior because it reduces the chances of investing just prior to a market drop. If you instead decide to invest 1/6th of the money each month for 6 months, you will reduce the chance of buying just before a crash. Instead, as the price fluctuates each month, you will buy more shares when the price is low and less when it is high.

Many new investors are more interested in minimizing their their potential regret, and it's important that an ill-timed market drop not scare them off from investing in the future. Many experienced investors are more interested in maximizing their expected returns. You can also decide to split the difference, where you invest half immediately and the other half over 6 or so months.

Costs
Most mutual funds allow small, regular investments with no fees. However, most investors pay a commission to purchase an ETF. Depending on the size of the commission and the investment, DCAing into an ETF could be far more expensive than purchasing as a lump sum. For ETFs, the bid/ask spread is the same between DCA and lump sum.

Periodic Investing
Most investors make regular contributions through their 401(k) plans or by having a set amount auto-deducted from their bank account into an IRA or taxable account. When this money is automatically invested, it has the same benefit of dollar cost averaging that you buy more shares when prices are low and less when they are high. However, this form of investing is not dollar cost averaging. It is called periodic investing. The difference is that periodic investing is maximizing expected return, because you are investing the money as soon as you have it. DCA applies when you have the money to invest, but delay doing so.

Switching to a More Conservative Portfolio
Some investors who are new to a Bogleheads Investment Philosophy may find their portfolios contain too much equity. Even worse, some investors have a large portion of their net worth held in a single stock, such as through an employee purchase plan. They generally want to sell some of their equities and buy bonds. In these cases where an investor wants to move from high risk and volatility assets to lower risk and volatility assets, a lump sum transaction makes more sense than DCA. That's because lump sum both immediately moves to the expected return and volatility the investor wants, while also minimizing potential regret.

Links

 * Wikipedia on Dollar Cost Averaging
 * Do Not Dollar-Cost-Average for More than Twelve Months, Bill Jones, Efficient Frontier, October, 1997.