Dollar cost averaging vs lump sum investing
What is the meaning of life? Am I a cat person or a dog person? We try to answer an easier age-old question – dollar cost averaging vs lump sum investing.
One of the most popular questions for investors at the beginning of their journey is whether they should invest with lump sums or dollar cost average. Lump sum investing is putting your funds into the market as a ‘lump sum’ – pretty self-explanatory. Dollar cost averaging is the process of investing a sum in parts, to lower the ‘risk’ of investing at a poor price. For example, if you had $50,000 to invest:
Or, you have a $10,000 lump sum to invest, there are multiple outcomes. In this hypothetical scenario green outcomes are when you would have done better than the dollar-cost average scenario. Red represents times when you wouldn’t have.
Keep this hypothetical scenario in mind.
Morningstar has conducted a study on the two strategies. Vanguard has also conducted a comparable study. The results are fairly similar – lump sum investing trumps dollar cost average in the majority of scenarios. Markets go up more than they go down which means a longer time in the market means more time for investment returns to compound. An added benefit is less brokerage and transaction fees.
Case closed…right?
One interesting thing about this debate is that most investors don’t really have a choice. It is very rare that we have lump sums to invest. Inheritances, redundancies, lottery wins, proceeds from downsizing – these are once off occurrences at best except for the fortune few who receive multiple windfalls.
If you are a salaried employee, contractor or anyone with recurring income, you are likely investing pay check to pay check. This makes you a dollar cost averaging investor whether you want to be or not. An example is an employer contribution going into your superannuation.
What many investors are really asking is if they should invest each time they get paid or hold onto the funds until there is a larger sum to invest. Let’s take a deeper look into the data to consider this scenario.
The circumstances that suit either strategy
When DCA works
Morningstar’s study explored specific periods of market history to see how a 60/40 stock bond split and an all-equity portfolio would have fared using the competing strategies. In around one third of circumstances run in the model, dollar cost averaging (DCA) worked out better than lump sum investing (LSI). The circumstances where DCA outperformed were mainly in market downturns where investors were falling prices were bringing down the average cost basis with each investment.
Let’s put some numbers to this. In the technology correction from March 2000 – October 2002, dollar cost averaging into an all-equity portfolio limited losses to 1.75%. Lump sum investors would have an annualised loss of 13.84%. Over a longer time horizon, the all-equity portfolio still suffered.
When lump sum investing works
In periods with positive total returns, dollar-cost averaging fared worse. During the sustained bull run after the GFC, both the all-equity and 60/40 portfolio fared better with lump sum investing.
The purpose of DCA is to apply the strategy over short time periods to combat short-term volatility.
I have found that this chart has always helped add some perspective. Although it is US-based, the same principle applies to Aussie investors. It mimics the hypothetical scenario at the beginning of this article. In most market environments large swings in share prices are rare over the short-term.
Should I save larger parcels, or invest in smaller parcels?
Depending on your definition of lump sum, the alternative is to keep funds out of the market for long periods of time until you can gather a lump sum. There is an opportunity cost here – the growth and compounding that is missed as you sit out of the market. On the other hand, there’s transaction and brokerage costs from investing more frequently.
Deciding between investing immediately or saving for a larger parcel means considering a few factors:
- Any brokerage or transaction costs that are incurred
- Any additional investment minimums that you must meet
- The period that you are not invested in the market
What if I do have a lump sum to invest?
There are circumstances where investors do have a lump sum to invest.
Most days that the stock market is open, the market moves between -1% and 1%. Except during periods of extreme volatility, you do not need to ‘smooth out’ your returns as much as it may seem. The data shows that the reduction in volatility that many people attribute to DCA is trumped by the advantages of more time in the market offered by lump sum investing.
For long-term investors, the most important thing to understand is that markets have historically always trended up over the long-term. Being invested over the long term means that you not only avoid transaction and brokerage fees but also can capitalise on more time in the market.
The determination?
Ultimately, lump sum investing gives you the best chance of success. It gives you the most time in the market and lowers brokerage and transaction costs. The only markets where lump sum investing underperforms DCA are declining markets where lower unit prices are captured. To take advantage of these situations means an investor would have to know the market was dropping. Speculation on the short-term direction of the market is rarely succesful.
What the research is showing us is that we should invest whenever we have enough money to make it feasible. This is when transactions fees and minimum additional investments amounts are not prohibitive.
I suspect that many investors are using this debate and switching between both options as a way to justify market timing. They invest when they believe the market is attractive and build up cash when they don’t. It has been shown time and time again that timing the market does not work. We can take a look at US figures here, but the lesson still applies to Australian investors. Over the last 30 years, if you missed the S&P 500's 10 best days, your return would be cut in half. If you missed the best 30 days over the last 30 years, your return would be 83% lower.
This is why timing the market, often thinly veiled as a strategic choice, is an issue. Not being invested in the right securities means missing most of those days. 78% of the best days occurred in a bear market. This is when the market appears risky and many investors believe they are strategically avoiding a poor investing environment. In my opinion, missing these days is a much larger risk than investing at a ‘risky’ time.
This is not an academic exercise for me. I’ve never had a windfall that gives me the chance to make a lump sum investment. I have decided that the best course of action for me is to invest from each pay check to support strong savings and investing habits.
In these circumstances, it is in your best interest to lower transaction and brokerage costs. These fees can add up over the long term and detract from your total return outcomes. To do this, I found products and services that charge no additional investment fees with extremely competitive transaction fees. They have low minimum additional investment amounts so my money can enter the market as soon as I have been paid. This lowers the risk that that I will engage in poor behaviour and try and time the market.
Like all decisions in investing, these are personal and specific to your circumstances. The data shows that lump sum investing is best for investor outcomes but this assumes that you experience a financial windfall. Most investors would be wise to follow this path provided transaction costs are reasonable.