I’ve always been suspicious of dollar-cost averaging, or DCA as it’s called. It just doesn’t seem like the wisest decision. I’ve always preferred lump sum investing.
Dollar-Cost Averaging vs. Lump Sum Investing
With DCA, rather than investing your cash all at once, you invest chunks of it over time. For example, you might invest $12,000 over the course of a year, $1,000 each month. In contrast, with lump sum investing, you’d put the full $12,000 to work right away.
The problem with DCA, as I see it, is that it depends on market timing.
With DCA, you’ll be better off only if the market declines while you’re investing your money. If the market goes up, you will wish you’d invested everything at once.
Check out my podcast on this topic, here:
Well, Vanguard released a study that (more or less) reached the same conclusion.
Called Dollar-cost averaging just means taking risk later (pdf), the study compared the historical performance of dollar-cost averaging with lump sum investing (LSI). The results?
On average, we find that an LSI approach has outperformed a DCA approach approximately two-thirds of the time, even when results are adjusted for the higher volatility of a stock/bond portfolio versus cash investments. This finding is consistent with the fact that the returns of stocks and bonds exceeded that of cash over our study period in each of these markets.
Vanguard then provided the following explanation:
We conclude that if an investor expects such trends to continue, is satisfied with his or her target asset allocation, and is comfortable with the risk/return characteristics of each strategy, the prudent action is investing the lump sum immediately to gain exposure to the markets as soon as possible. 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.
The study’s results are interesting because many promote dollar-cost averaging as the way to enter the market. Yet CNN published a piece on the downside of DCA, as did Market Watch and my friends over at MSN.
The Vanguard report took it all a step further and actually put numbers into the mix.
The report examined the possible outcomes of two investors: one who invested each month for a year versus one who made a lump sum investment. Vanguard used rolling 10-year historical investment returns to see which option turned out better.
The conclusion was that lump sum investors come out on top 67% of the time versus just 33% for those using DCA.
The result was a 2.3% improvement using lump sum over dollar-cost averaging.
It’s important to note here that investing in a 401(k) each paycheck is a great option. While it looks a lot like dollar cost averaging, it’s really not.
The difference is that you are investing what you can each pay period. It’s not as if you are intentionally holding onto more money, waiting to invest it next month.
The Vanguard report made this clear:
Most popular commentary addresses DCA in terms of consistent investments made using current income—i.e., an employee transferring a portion of each paycheck into a retirement account. In that case, investable cash becomes available only in relatively small amounts over time, which makes DCA a prudent way to invest (and really the only sound alternative to accumulating that money in cash and then actively trying to time the market at some later point). Our research, in contrast, focuses on the strategies for investing an immediately available large sum of money. Here, the average performance results have favored lump-sum investing.
Dollar-Cost Averaging & Behavioral Finance
Let’s put the math aside. There is one situation where dollar-cost averaging might be the best choice.
Imagine you’ve come into a lot of money. You may have received an inheritance or a pension payout. Or maybe you won the lottery. A lump sum investment could see your portfolio drop by 20% or more if you invest just before a bear market.
The result could be emotionally devastating. It might even affect the way you see investing for the rest of your life.
It was a point Paul Merriman brought up in a recent podcast. Here, it would be better to dollar-cost average into the market over, say, 12 months.
You may or may not be better of than lump sum investing. You would, however, lessen the effect of a major market downturn.
So, which approach do you think is best?