DR 071: Dollar-Cost Averaging Versus Lump Sum Investing–Which is Best?

I‘ve always been suspicious of dollar-cost averaging. With DCA, rather than investing the cash you have 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 during the period of time you are investing your money. If the market goes up, you will have wished you’d invested everything at once.

Vanguard just released a study that reached the same conclusion (more or less). Called Dollar-cost averaging just means taking risk later (pdf), the study compared the historical performance of dollar-cost averaging with lump sum investing. 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 results of the study are interesting because dollar-cost averaging has been a widely promoted 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. Assuming that an investor invests each month for a year versus a lump sum investment, the report examined which investor would be ahead 10 years later. Vanguard used rolling 10-year historical investment returns. The conclusion was that lump sum investors come out on top 67% of the time versus just 33% for those using DCA.

Dollar Cost Averaging vs. Lump Sum Investing

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 way to invest. While it looks a lot like dollar cost averaging, it’s really not. You are investing what you can each pay period. It’s not as if you are holding on to more money and waiting to invest 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.

So which approach do you think is best?

Topics: Investing

13 Responses to “DR 071: Dollar-Cost Averaging Versus Lump Sum Investing–Which is Best?”

  1. Jim Astor

    Key statement in your article is “immediately available large sum of money”. That’s great for the “Romneys” of the world. Most people are investing through 401k’s and, as you correctly point out, they are investing what they can with each paycheck. One thing I would do, if I had a sum of money to invest, is to wait for a down day in the market rather than invest on a day when the market has hit new highs.

  2. DCA is entirely a risk management issue. Sure, “on average,” lump sum investment yields better results, except when it doesn’t. The problem is that no one knows in advance when that will be. When one dumps in a large sum of money into an investment, not only is the entire amount put “to work,” it is also put at risk. If someone had been investing in the S&P over much of the last decade, most scenarios would have the dollar-cost-averager coming out ahead; and certainly with far less risk, regardless of the results. Bottom line: The upward potential is reduced, but risk is reduced to a much greater degree.

    If one has money to “play with” in the market, go ahead and speculate, gamble, and dump in funds as one sees fit. If one has limited means and needs every penny available to survive in retirement, then one needs to stick to traditional rules of asset allocation and systematic investing.

    Rob Drury
    Executive Director,
    Association of Christian Financial Advisors

  3. At this point of my life I tend to do DCA approach for the last 10 years because I am more comfortable with this investing style. Granted if I had 10 grand above and beyond my emergency fund for play money and my favorite stock dropped 25% in price, then I would be very tempted to do a lump sum.

    • Rob Berger

      What you’re comfortable with is important. Studies like Vanguard’s provide good information, but an investing style you’re not comfortable with will never work out in the long run.

  4. DCA tends to be more about minimizing “regret”, which is certainly not something to be ignored. However, there is a long-term upward bias to the market, and that’s why most of us invest, Thus, mathematically you would expect that lump sum would outperform DCA, so the Vanguard results don’t surprise me.

    • Also interesting Vanguards study is published just as the market is reaching new highs. That said, the market has more up days than down days so one would expect DCA to cost more over time; however, as Vanguard points out, a good market entry point trumps DCA about 33% of the time.

      Given todays market levels, If I had a lump sum to invest, I’d begin DCA it unless the market corrected 10% or more then lump sum invest the rest.

  5. peas & gravy-davy

    when i first saw graph i thought—holy sh^t—-lump sum returns 30%+ more than dca

    then read smallprint—-a 30% chance of out performing dca–so 70% not

    a 2% diff in returns–how many investors have lumpsums?

    over long term i want to build up capital with a fixed amount monthly budgeted for

    i wont be the richest—–but i can sleep at night—an will look forward to my lump sum end of journey

  6. Having been a broker for a number of years, mostly with a large BD that utilized mutual funds as its main investment offering to its clients, I cannot stand DCA. It’s a mind numbing, the market always goes up, tax nightmare. I’m not sure what I do would be considered lump sum investing, but I always have a healthy amount of cash on hand because the market always gives you opportunities. I talk about those opportunities on my blog: everyinvestor.blogspot.com It deals with the market direction and duration.

  7. The whole point of DCA is that no one can time the market prospectively. Sure if you knew when to make your lump sum investments that would be great, but none of us know what the market is going to do tomorrow. So with DCA you make small installment investments over a long time horizon, and sometimes the market goes up and sometimes it goes down, but in the long run you never put too much in before a large crash and you never put too much in before a large rally, but you end up not losing your shirt. And like others said, DCA is not for millionaires deciding to put it all in or put it in over time, its for average people saving over their lifetime. that Read the work of William Bernstein and the like for more detailed explanation of DCA and it’s benefits.

  8. Trevor Miles

    I have done a mix of both; to me the 401k is “indirect” DCA because I am making 26 purchases a year. In the past I have rounded up some cash, and then brought a particular fund.
    However, since purchasing a target fund last year I am DCA-ing it every 2 weeks.
    Since it does not have enough bonds; I will exchange some of it for a bond fund (taxes shouldn’t be too bad so far this year).
    I am not doing this to try and do market timing, it is more for budgeting.
    For example, if I put in X amount for 10 weeks then after 10 weeks I would only be putting in x in the 10th week vs 10x- and gradually holding cash along.

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