Dollar cost averaging or lump sum investing?
Recently, several friends and subscribers to my YouTube channel have asked me about dollar cost averaging. They want to know whether they should invest a windfall immediately, as one lump sum, or over time. While there is no one “right” answer to this question, there are several factors to consider.
1. We Don’t Know the Future
It’s important to accept that we cannot know in advance whether lump sum investing or dollar cost averaging will lead to the better outcome. In the words of Yogi Berra,
It's tough to make predictions, especially about the future.
It's important when it comes to investing that we understand the limitations of our knowledge. Don’t be fooled by investment news that’s filled with market predictions. As Warren Buffett says, a stock market prediction tells us more about the prognosticator than it does the future.
Even if we knew where the market would stand a year from now, we still wouldn't know whether lump sum investing or dollar cost averaging would lead to the best result. Why? Because the outcome would depend on how the market performed during the year. If it fell and then rose, dollar cost averaging would take advantage of the lower prices. If it rose and then fell, lump sum investing would lock in the lower price at the start of the year.
2. History Favors Lump Sum Investing
While there’s a lot we don’t know, we do have several factors that can help us make a reasonable decision. Vanguard published a study in 2012 that compared lump sum investing with dollar cost averaging. Here's how the study worked:
Vanguard looked at three different markets—the United States, United Kingdom and Australia.
It then examined rolling 10 year periods from 1926 to 2011. The rolling periods incremented by month, so Vanguard examined over 1,000 10-year rolling periods.
It considered different stock/bond allocation.
For dollar cost averaging, Vanguard looked at periods ranging as short as six months to as long as 36 months.
Vanguard found that at the end of the 10-year period, lump sum investing beat dollar cost averaging about two thirds of the time. The results were consistent across the U.S., the United Kingdom, and Australia.
If you're a numbers person and want to take the approach that gives you the best chance of having more money, then according to this study, lump sum investing would be your best approach.
3. Avoiding Losses Favors Dollar Cost Averaging
Some of you may be more concerned about losing money than you are maximizing your returns. Vanguard’s study provides insight into this perspective as well. What it found was that during a down market, dollar cost averaging resulted in losses less frequently than lump sum investing. Specifically, the study found that lump sum investing declined in value 22.4% of the time. Dollar cost averaging was down 17.6% of the time.
So if your concern is preservation of assets, dollar cost averaging might be the better approach.
4. The Difference is Modest
While lump sum investing wins out most of the time, the difference is relatively small. Assuming a 60/40 portfolio in the United States, lump sum investing beat out dollar cost averaging after a 10 year period by 2.3%. So I don't think we're talking about huge sums of money. While I'm a big believer that every basis point counts, for most of us it's probably not a life changing decision.
5. Consider Your Risk Tolerance
Our emotions can get us into trouble when it comes to investing. That’s true when we get scared, and it’s true when we get excited. Both can lead us down the wrong path. Vanguard highlighted this fact in its study:
But if the investor is primarily concerned with minimizing downside risk and potential feelings of regret (resulting from lump-sum investing immediately before a market downturn), then DCA may be of use. Of course, any emotionally based concerns should be weighed carefully against both (1) the lower expected long-run returns of cash compared with stocks and bonds, and (2) the fact that delaying investment is itself a form of market-timing, something few investors succeed at.
If an investor goes all in with a lump sum investment and then the market craters, it could have a negative effect on them for years to come. To protect against this outcome, dollar cost averaging may be the better approach. However you choose to invest a windfall, it's important to think about the emotional side of investing, not just the numbers.
6. Follow a Plan
You should always have an investment plan. If you want to dollar cost average, come up with a plan, put it in writing and stick to it. For example, you may decide to dollar cost average over 12 months. You're going to take one-12th of your money and invest it in each of the next 12 months. Put the plan in writing and then do it no matter what.
Following a plan helps us avoid marketing timing. We don’t know how the market will perform in the future. That's why it’s so important to come up with a plan, put it in writing, and stick to it. We should do that with our asset allocation plan and our approach to rebalancing.
