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.

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.

This episode goes through the circumstances that suit each strategy, and what happens if you do have a lump sum to invest.

You can find the full article here.

 

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You can find the transcript below:

Mark LaMonica: So, Shani, you have something you call personal KPIs.

Jayamanne: Yes, I do, Mark. They're things that I want to achieve each day.

LaMonica: And one of those KPIs is that you keep up to date with the latest news.

Jayamanne: Yes. And I do that in a few ways, but I do it with podcasts each morning. And one that I've just added to my morning routine is ANZ's 5 in 5.

LaMonica: Which is great for us because they've decided to sponsor this podcast, and it's something that you actually listen to.

Jayamanne: It is, Mark. And what I really like about it is that it has a similar approach to us. ANZ leverages the insightful experts that they have across their global network to provide a rounded and level-headed analysis of the latest economic, markets, and business news each weekday.

LaMonica: So, thank you to ANZ's 5 in 5 for sponsoring this episode of Investing Compass. Each episode will go through five top insights to start your morning. You can find them in your preferred podcast player or click the link in the episode description to follow them and have a listen after us.

Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into account your specific situation, circumstances, or needs.

Jayamanne: We've got a really exciting episode today, Mark, and it's not the content. It's because we have…

LaMonica: Well, I hope the content is exciting as well.

Jayamanne: It is. But we've also got a guest, and the guest is Will. Will has been involved with Investing Compass since the beginning. He produces the podcast. He makes us sound good. He makes the episodes actually sound good. We make a lot of mistakes during them. So, he produces the podcast, and he's also going to pick the winner for the survey.

LaMonica: And the winner gets again…

Jayamanne: A $250 Visa gift card.

LaMonica: And thank you very much for everyone who has completed the survey. So, Shani has come up with some system.

Jayamanne: Yes. So, I've taken all of the people that have responded to the podcast, and I've created an even number, so 10,000. And so, you've got multiple entries if you have responded to the podcast. So now, Will is going to pick a number between 1 and 10,000.

LaMonica: All right. Go for it, Will.

Will: That was a great intro, Shani. Thanks for that. You just put a little bit more pressure on me now. So, do I just pick a number, right?

Jayamanne: You pick any number.

Will: Okay. So, the number is 2,909.

Jayamanne: Okay. 2,909. So, we have – and we don't have your names on this, and I've just got your emails. So, I'm going to guess.

LaMonica: And you're not going to read the whole email, of course.

Jayamanne: No, no. There's definitely privacy issues with that one. But I'm going to guess this is a Fiona. So, Fiona, we will be in touch with your gift card. And thank you so much to everyone who did participate in the survey. It really helps us a lot and make sure that we can keep the podcast going.

LaMonica: Okay. So hopefully, the excitement is not over…

Jayamanne: No.

LaMonica: …at this point, because we can actually get into the episode, Shani.

Jayamanne: Yes. And today is a quick one, but we're going to take a look at one of our most asked questions. And it's asked by investors who are just starting out, but it's also asked by investors who may, later in their investing journey, come into a lump sum of cash.

LaMonica: And that is whether you should dollar cost average or invest it all in a lump sum.

Jayamanne: And we've done a few episodes and articles recently on inheritances. And this is going to be a common question that will pop up in the future as lump sums are received as inheritances, and those that receive the lump sums are looking to invest it and put it to work. So, we'll have a look at it from that perspective, but we'll also look at it a bit more generally too. What should you do on a day-to-day basis?

LaMonica: Okay. So, we'll start with some definitions as we always like to do in these episodes.

Jayamanne: So, a lump sum is pretty self-explanatory. It is investing in one go with all the money you have at hand.

LaMonica: And dollar cost averaging is the process of investing that sum in parts. And many investors choose to do this to lower the perceived risk of investing. So, let's go through an example because we love examples, Shani. So, let's say you have $50,000. So, you invest that $50,000 in one go. Let's say you're buying shares that cost $5 a share and you've got 10,000 shares.

Jayamanne: The other option is investing in five lots at $10,000. You might get a share price of $5 for one lot. You might get a share price of $450. You might get a share price of $550. The point is that you have hedged against market anomalies. So, if the share price surges one day with the market and you're buying at $7, you haven't locked in that price over the whole amount. You have the opportunity to spread your risk.

LaMonica: Okay. So, we love a study. And by we, it's mostly you, Shani. You love a study. And there are two studies that we're basing this episode on. The first is a Morningstar study. And the second is a Vanguard study. And the results are fairly similar, which is good.

Jayamanne: Yeah. And we're going to give away the outcome at the beginning of this discussion, but we will go into some of the specifics and limitations of the studies. But the result is that 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 horizon in markets means more time for investment returns to compound. And an added benefit is less brokerage and transaction fees.

LaMonica: All right. So, case closed, Shani. You gave away the results of the study right at the beginning. So now we can just end this podcast, right?

Jayamanne: Yeah. I can go home. Will can go home. You've still got a meeting, so you can't go home.

LaMonica: Well, that seems to work out very well for the two of you. But of course, we're not going to end the episode right here. The issue is that, of course, a study is just a study. It can look at historical applications and the best decision in theory but ignores the realities of life and these strategies in practice.

Jayamanne: And that is because one interesting thing about this debate is that most investors don't really have a choice. It's very rare that we have lump sums to invest. Inheritances, redundancies, lottery wins, proceeds from downsizing. These are mostly one-off occurrences at best except for the fortunate few who receive multiple windfalls, like we mentioned.

LaMonica: That was an interesting list that you put together. So, like two good things and two bad things.

Jayamanne: Yes.

LaMonica: Except for you…

Jayamanne: You have to be fair.

LaMonica: …who every day hopes that you get a redundancy.

Jayamanne: That's true.

LaMonica: Yeah. Well, anyway.

Jayamanne: Just make my wish come true, Mark.

LaMonica: Yeah. I do not have that power. But if you're a salaried employee, a contractor, anyone with recurring income, you are likely investing paycheck to paycheck. That means you dollar-cost average whether you want to or not. An example is an employer contribution going into superannuation.

Jayamanne: So, I think what investors are asking is different to what the study is looking at.

LaMonica: What many investors are really asking is if they should invest each time they get paid or hold on to the funds until there's a larger sum to invest. So, let's take a deeper look into the data to consider this scenario.

Jayamanne: So, we can start with the circumstances that suit each strategy and we can take a look at DCA first. So, Morningstar 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. So, in around one-third of circumstances run in the model, DCA worked out better than lump-sum investing. The circumstances where DCA outperformed were mainly in market downturns where falling prices were bringing down the average cost basis with each investment.

LaMonica: So, for example, you're investing every month, and the market is falling, you might invest at $1 than $0.90, than $0.80. And over the long term, when the market recovers, you'll have purchased at lower prices. A real-life example was the technology correction from March 2000 to October 2002.

Jayamanne: Yeah, and they show that in the study and you can find the graphs in the article that I've written about this, and we'll link that in the episode notes. But dollar cost averaging into an all-equity portfolio limited losses to 1.75%. Lump-sum investors would have had an annualized loss of 13.84%. But over a longer time horizon, the all-equity portfolio still suffered. But for the 60-40 portfolio, lump-sum investing won out. It was also the top performer out of all of the portfolios.

LaMonica: And Shani, as she mentioned, has written an article on this. So please take a look at the graphs that she put in there. She's very proud of all her graphs, although she did just copy them from the study.

Jayamanne: I did, yes.

LaMonica: Yeah, to be fair. It shows the exact impact of dollar cost averaging versus lump-sum for the 60-40 portfolio and the all-equity portfolio.

Jayamanne: Okay, but before we do move on to lump-sum investing and how it works, just a reminder, if you do want to hear the top five global market updates from around the world, click the link in the description for 5 in 5 with ANZ's podcast. Okay, so lump-sum investing, take it away, Mark.

LaMonica: In periods with positive total returns, dollar cost averaging fared worse. During the sustained bull run after the GFC, both the all-equity and the 60-40 portfolio fared better with lump-sum investing. And ultimately, the market has always trended upwards in the long term.

Jayamanne: But investors aren't stupid, they know this. When we speak about dollar cost averaging, investors really want to know whether they do it over short-time periods to combat short-term volatility. We know that markets have historically trended up over the long term. Logically, this means that lump-sum investing will always come out on top. Get into the market as soon as possible.

LaMonica: But I think what helps is understanding how the market usually behaves. There's a chart that we've included in the article – that Shani included in the article – that illustrates this. But it visualizes every day of the U.S. stock market for the last 10 years. And overwhelmingly, the market moves between negative 1% and plus 1%. There are few days that move more than 2% and there are very few that move more than that.

Jayamanne: Of course, this is looking at a market as a collective. In most market environments, large swings in share prices are rare over the short-term, collectively speaking. So, it is rare that you have much to gain from dollar cost averaging with blue chip stocks or the broader market, especially after you consider transaction costs.

LaMonica: But of course, there are exceptions. The issues come when you're investing in a particularly volatile stock that may not follow this pattern, especially if there are volume issues. Then you might be forced to DCA when you are trying to fill your order with a lump sum anyway.

Jayamanne: So, with studies aside and the theory aside, the question really is, should you save and then invest large parcels or invest in smaller parcels immediately?

LaMonica: And this really depends 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's an opportunity cost here. The growth in 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.

Jayamanne: Deciding between investing immediately or saving for a larger parcel means considering a few factors. They are – any brokerage or transaction costs that are incurred, any additional investment minimums that you must meet, and the period that you're not invested in the market.

LaMonica: Okay, so, Shani, what if you do have a lump sum to invest?

Jayamanne: Are you offering one?

LaMonica: Yeah, how big you consider a lump sum?

Jayamanne: Okay, okay. Most days the stock market is open, the market moves between minus 1% and 1%, as Mark said. Except during periods of extreme volatility, you don't 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.

LaMonica: For long-term investors, the most important thing to understand is that markets have historically always trended up over the long term, as we've said. Being invested over the long term means that you not only avoid transaction and brokerage fees, but also can capitalize with more time in the market.

Jayamanne: So that's the determination. Ultimately, lump sum investing gives you the best chance of success. It gives you the most time in the market and lowers those costs. The only market 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 this short-term direction of the market is rarely successful.

LaMonica: What the research is showing us is that we should invest whenever we have enough money to make it feasible. This is when transaction fees and minimum additional investment amounts are not prohibitive.

Jayamanne: 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's been shown time and time again that timing the market doesn't work. We can take a look at the U.S. figures here and we've gone through this before, but the lesson still applies to Aussie 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.

LaMonica: And that right there 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. And we think missing these days is a much larger risk than investing in a risky time.

Jayamanne: And 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've decided that the best course of action for me is to invest from each paycheck to support strong savings and investing habits. What I do need to be cognizant of is the downside of this, and that's the costs. In these circumstances, it is in your best interest to lower those costs. And these fees can definitely add up over the long term and detract from your total return outcomes. So, what I've done is I've 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. And this lowers the risk that I'll engage in poor behavior and try and time the market.

LaMonica: And to be clear, Shani, you do not wait until you are paid.

Jayamanne: No, I don't.

LaMonica: She is very impatient, so she just transfers money out of her savings like 10 days before we get a paycheck.

Jayamanne: Yeah.

LaMonica: It's very strange.

Jayamanne: They're going to be in the bucket.

LaMonica: Yeah, it's very strange behavior, Shani. But anyway, she is just so excited about investing, which hopefully comes across, right?

Jayamanne: Yes.

LaMonica: But like all decisions, including Shani's strange decisions, there are personal and specific reasons that you would do a certain thing. 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.

[Advertisement: Investing Compass is a podcast we started to explore the fundamentals of investing and help you with achieving your financial goals, whatever they may be.

ANZ's 5 in 5 have sponsored this episode of Investing Compass. We also listen to 5 in 5 ourselves to keep up to date with the latest economic, markets, and business news each weekday. One of the things that we like about the podcast is that it has a similar approach to us. They leverage the insightful experts that they have across their global network to provide a rounded and level-headed analysis of news and insights each weekday.

You can find them in your preferred podcast player or click the link in the episode description to follow them and have a listen after us.]

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)