Dollar Cost Averaging vs. Lump Sum Investing

Today, we're going to put Dollar Cost Averaging (DCA) up against Lump Sum (LS) investing.

Let's start with defining each:

DCA is consistently buying into the market (usually on time intervals) with the same $ amount and zero consideration of current market conditions.

Example - you have an automatic investment of $800 every 1st of the month into a total stock market index fund.

Why does this work well?

Because it buys in at different price points.

Sometimes your $800 may buy you 3 shares of your favorite index fund.

But when the market drops?

That same $800 may be able to buy you 5 shares of your favorite index fund.

This means you are buying into the market at discounted prices.

DCA is a powerful way to invest.

But spoiler: Lump sum investing beats DCA 2/3 of the time when you have the opportunity to choose between LS and DCA.

To clarify:

This is not Dollar Cost Averaging into your 401(k) with every paycheck.

This is when you have a large sum of money (maybe from an inheritance or large bonus) and are considering 2 options:

1) Lump-sum: invest the entire amount at once, or

2) DCA: invest it over a period of time.

Example - You just received a $50,000 bonus. You want to invest $24,000 of it into the market:

You can either:

1) Invest the entire $24,000 into the market right away (lump sum), or

2) Invest it over a period of time: $2,000/month for 12 months (dollar cost average).

Which one should you do?

Thankfully, Vanguard and Nick Maggiulli (https://ofdollarsanddata.com/) did the research on this.

Let's dive in.

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The Results

I don’t want to keep you waiting:

LS outperforms DCA most of the time for most asset classes.

And DCA beats staying in cash.

This may surprise you, but the reasoning is simple:

The market has a positive annual return about 70% of the time.

And when a portion of your money is in cash (rather than invested), you miss out on these positive returns.

So now that we know LS usually wins, just how bad is the underperformance from DCA?

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Underperformance

It varies with the buying period:

With the above example ($2k/month for 12 months), your buying period is 12 months.

This means at the end of the 12 months, you will be entirely invested.

For 12 months, DCA underperformance is 3.7% on average.

24 months? 10%

5 years? 17% (Yikes)

The longer the buying period, the worse DCA performs.

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Other Asset Classes

The above numbers are based on investing in the S&P 500 but what about other asset classes?

DCA still underperforms most of the time over 24 months:

We’ve seen here that Lump Sum wins most of the time.

So when does it lose?

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When Lump Sum Loses

Lump sum loses when your invest into a market crash.

Hopefully, this isn't surprising.

If you had used DCA, you’d have the benefit of buying into a falling market (and keeping some money in cash).

Numbers are one thing, but what about the risk you’re taking on?

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Evening out the Risk

Most people prefer to dollar cost average instead of lump sum invest because the idea of putting all of your money into the market at one time seems really risky.

And it is riskier.

And again, the reason is simple: keeping some of your money in cash decreases your risk.

But what if we even out the risk?

What does it do to the results if we lump-sum invest into a 60/40 portfolio (60% stocks and 40% bonds) vs. Dollar Cost Average into a 100/0 (100% stocks and 0% bonds) portfolio?

The result using the timeframe of 1997-2002:

Lump sum still outperforms in most time periods with the same risk.

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Investing the Cash

Now, let’s talk more about the “cash” component of Dollar Cost Averaging.

The above results assume that your cash isn’t making any money.

But what if you were to invest that cash that’s sitting on the sidelines into T-Bills?

The result:

DCA still underperforms but the underperformance shrinks.

Instead of underperforming 6-10% over 24 months, it shrinks to 4-8% over 24 months.

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Human Behavior

We’ve looked at the numbers, but this analysis of Dollar Cost Averaging vs. Lump Sum investing would be incomplete without including one of the most important variables:

Emotion.

Most people are far more comfortable slowly investing into the market rather than one lump sum investment.

The important thing here is that you get invested.

Both DCA and LS beat staying in cash over the long-term.

But here’s a point you need to remember:

If you choose to DCA instead of LS, it’s critical you stick to the strategy and buying period.

Why?

Because DCA is easy to stick to when the market is rising, but it actually works best when the market is falling.

And psychologically, a falling market is the most difficult market to buy into.

This means DCA works best when it’s most difficult to execute.

So if you do decide to DCA, it’s important to remember to :

• Keep the buying period short.
• Invest the cash on the sidelines in a stable instrument.
• Stay committed to the process.

The above numbers and data come from these 2 sources:

https://ofdollarsanddata.com/dollar-cost-averaging-vs-lump-sum/#:~:text=Lump%20Sum%20(LS)%3A%20The,your%20available%20money%20over%20time

https://corporate.vanguard.com/content/dam/corp/research/pdf/cost_averaging_invest_now_or_temporarily_hold_your_cash.pdf