Called – Earlybirds Invest

Many financial experts tout dollar-cost averaging as a smart way to invest your money in the stock market. Warren Buffett disagrees, at least in some cases.

Dollar-cost averaging is a strategy in which you take a set amount of cash and invest it in securities on a periodic basis. It’s often advised for investors sitting on a lump sum of cash who want to minimize their risk of paying too much for a stock.

There’s no investor sitting on more cash than Warren Buffett right now. Berkshire Hathaway (BRK.A 0.59%) (BRK.B 0.53%) ended the first quarter with more than $348 billion in cash and Treasury bills. But Buffett has been fine stacking cash and waiting for an opportunity in the market. At Berkshire’s shareholder meeting this year, he even went so far as to say if he was forced to invest $40 billion or $50 billion per year from the cash pile and Berkshire’s operating cash flow, “that would be the dumbest thing in the world to invest in that manner.” He’s not going to dollar-cost-average into the market with Berkshire’s money.

But Buffett did carve out a key exception for some investors. And it might be one of the smartest things you can do with your money.

Image source: The Motley Fool.

What game are you playing?

When it comes to investing, there are a lot of different routes you can take. A far-from-exhaustive list includes:

Trading: Looking to take advantage of short-term price changes in a specific security.
Speculating (as venture capitalists do): Putting a lot of small bets on promising businesses, with expectations that only a handful will actually pay off while the rest go to zero.
Buy-and-hold investing: Buying stakes in companies with expectations for long-term appreciation.
Passive investing: For instance by buying index funds that aim to match the returns of a set benchmark.

There are many different tactics you can use to play each of those games, and each of them is winnable.

Buffett has played multiple games in his lifetime, but his most successful game by far has been buy-and-hold investing. Berkshire Hathaway’s average annual return for shareholders is nearly double that of the S&P 500 since Buffett took over in 1965.

One of the key tactics Buffett uses to succeed at buy-and-hold investing is remaining patient and ensuring he’s well-positioned to take advantage of opportunities when they inevitably arise. “We have made a lot of money by not wanting to be fully invested at all times,” he told the audience at this year’s shareholder meeting. Sitting on cash gives Buffett the flexibility to take advantage of the rare opportunities that offer extremely high upside.

He made incredible investments in the wake of the financial crisis (including Bank of America). He was able to put tens of billions of dollars into Apple stock when it traded at an unreasonably low valuation. More recently, he had a once-in-a-lifetime opportunity to invest in Japanese trading houses. But similar opportunities aren’t popping up every month. As a result, Berkshire Hathaway has seen its cash reserves pile up to record values in recent quarters, as Buffett awaits another great opportunity.

That’s the tactic that’s served him well. And anyone emulating Buffett will likely do best by keeping some cash reserves in their portfolio most of the time. With valuations climbing to the levels they’re at today, combined with relatively high interest rates on cash savings, piling up some cash right now makes a lot of sense.

But if you’re playing a different game than Buffett — and many people are — he takes a totally different attitude to dollar-cost averaging.

The big exception

If you’re not trying to beat the average returns of the S&P 500 or some other benchmark index, the best thing you can do is invest in an index fund. But if you want to ensure your returns match the index, you must be fully invested.

“We don’t think it’s improper, actually, for people who are passive investors just to make a few simple investments and sit for their life in them,” Buffett told shareholders, suggesting that remaining fully invested in an index fund at all times is a good strategy for many.

Where dollar-cost averaging does make sense — and I think Buffett would agree — is when it applies to setting aside some cash from your earnings and systematically investing the same amount every month (or whatever period makes sense).

However, if you’re a passive investor already sitting on a lump sum of cash, Buffett would likely suggest you invest that in your index fund of choice immediately. Indeed, the expected value of a lump-sum investment is considerably higher than dollar-cost averaging over time. That’s because stocks, on average, increase in value.

Unfortunately, many investors fail to adhere to Buffett’s lone exception to dollar-cost averaging. They forget what game they’re playing. As a result, the average index-fund investor ends up underperforming by 0.8% per year, according to research from Morningstar.

If you want to be a successful passive investor, you have to use different tactics than Buffett, the successful buy-and-hold investor. In some cases, that means doing the opposite of what he does.