Karl Hemmings & Alyssa Ng
Should I dollar-cost average or lump-sum my investment funds? This is a common question most investors will face at some point in time.
Let us begin by assuming you are fortunate enough to have a large amount of money that you wish to invest. Is it better to invest your money gradually over time (dollar-cost average) or invest it all in the market at once (lump-sum)?
The short answer is “it depends”.
In this article we will discuss the advantages and disadvantages of both investment approaches, as well as consider empirical evidence for and against, so as to enable you to determine which approach best aligns with your risk tolerance, future market expectations, financial situation, and goals.
What is Dollar-Cost Averaging?
Dollar-cost averaging is an investment strategy of allocating a fixed dollar amount to buy a particular investment (often an index fund) at periodic time intervals, regardless of the asset’s price. This strategy eliminates the stress of trying to time the market. For example, let us assume that during high school you worked part-time and saved up $12,000. Now, after taking FNCE10002 and learning about the eighth wonder of the world, that is, compound interest, you decide to invest in the ASX200. Under this investment strategy, instead of investing $12,000 at once in a lump-sum, you decide to invest 1,000 per month over the course of 12 months.
As you can see in Figure 1, assuming a constant dollar amount, fewer shares were bought when the market was ‘relatively’ high, and more shares were bought when the market was ‘relatively’ low. This process is expected to bring down the average cost per share in the long run.
What is Lump-Sum Investing?
Lump-sum investing (LSI) is a strategy of taking all of your money available to invest and putting it into the stock market right away. Continuing with the above example, this would mean investing the entire $12,000 at once in May 2020. In this example, because markets were in a strong upswing after the March 2020 crash, this student would have generated a 40.33% return with dividends reinvested, bolstering their initial $12,000 investment to $16,839.
This is an extraordinary return in just 12 months.
Now, let us consider what would happen if this student invested the $12,000 lump-sum at the beginning of February 2020.
Figure 2. Lump-sum investment into the ASX200 on February 3, 2020.
In this very unfortunate example, because of the sharp downturn in markets shortly after the initial investment, this student’s initial investment would have only risen by 4.13% to $12,496, with dividends reinvested.
This leads us into why many people choose to dollar-cost average. In this example, if the student had instead implemented a dollar-cost average investment strategy, he/she would have been significantly better off. However, it is not always the case that one particular strategy will outperform the other (higher returns), and the merits of each strategy will be discussed in the following section.
Why People Dollar-Cost Average
Dollar-cost averaging tends to appeal to people as it can offer the psychological comfort of easing into the market while reducing the risk of a market downturn. It is undeniable that emotions and fear can be hard to separate from decisions about money and investing. What if the market crashes right after you invest? With thousands of hard-earned dollars at stake, it might be hard trying not to think of the worst-case scenario.
By taking out the stress and emotions of trying to time the market, dollar-cost averaging can be soothing for investors who have weak stomachs when it comes to volatility. It may not promise a higher return (we will get this soon), but it can definitely elevate potential regret and help these investors sleep better at night.
Firstly, making smaller but more frequent transactions is likely to result in higher trading costs as most brokers charge a flat fee per trade. These fees can quickly add up and eat into returns while diverting money away from the investment process. As a quick example, if your costs are 5% of your initial investment and your returns are 6%, that’s just a 1% gain for your investment overall. Additionally, every dollar spent on fees is one less dollar left to invest and compound – just like the accelerating effect of compound interest, the same thing happens but in the opposite direction for investment fees.
Additionally, DCA might result in foregone gains when markets are trending upwards. By dollar-cost averaging, you are missing out on a larger position initially, and thus the full gain on a price rise had you invested all your money up-front. With markets tending to have an upwards bias, DCA investors are likely to lose out on greater gains over time.
Why People Lump-Sum Invest
A key benefit of investing all your money at the same time is the lower brokerage expenses compared to making multiple smaller investments. As mentioned earlier, lump-sum investing can also be advantageous during a rising market as you’re able to gain exposure right away and take full advantage of any market growth.
Additionally, lump-sum investing reduces the opportunity cost of idle cash. If you have a large amount of money sitting idle, these funds would be losing purchasing power due to inflation, and miss out on potential growth in the market. However, by putting your money to work immediately, you have a longer time horizon for your money to grow and allow the power of compounding to work its magic. This is particularly advantageous for lump-sum investors as stock markets tend to trend upwards in the long-term.
The obvious downside of lump-sum investing is the fact that you are putting all your eggs in one basket when it comes to timing the market. This is no simple task, and there is always the possibility that the market dips right after you’ve put in all of your money. While historical trends suggest markets will eventually correct, lump-sum investors are more exposed to short-term risks and losses. These periods of volatility are when emotions are likely to kick-in, and investors are at risk of making suboptimal investment decisions which lead to even greater losses.
What does the Historical Evidence say?
Irrespective of an investor’s risk aversion or time horizon, which investment strategy yields the greatest returns over the long run? Lump-sum investing or dollar-cost averaging?
In a 2012 paper from Vanguard (Investment management company) tilted “Dollar-cost averaging just means taking risk later”, the expected returns for lump-sum investing versus dollar-cost averaging were examined over 12-month periods from 1926 through to 2011 in the US, 1976 through 2011 in the UK and from 1984, through 2011 in Australia. Vanguard found that across equities, bonds and a 60/40 balanced portfolio split (60% equities, 40% bonds) in all geographic locations tested, lump-sum investing outperformed dollar-cost averaging roughly two-thirds of the time. Figure 3, illustrates the differences in expected returns for different portfolio allocations across varying geographic regions.
Figure 3. Relative historical probability of outperformance for LSI versus 12-month DCA at varying allocations
Now let us examine the difference in risk-adjusted returns for an investor who lump-sum invests versus an investor who implements a 12-month DCA strategy. The investor who implements the 12-month DCA strategy is lowering the overall standard deviation of the portfolio (risk) through the greater allocation to cash, a risk-free asset (excluding inflationary implications). However, Vanguard’s findings tell a similar story to before in that the degree of risk reduction does not compensate for the reduction in expected returns. That is, the Sharpe ratio for the lump-sum portfolio is greater than that of the DCA portfolio. Figure 4, illustrates the differences in Sharpe ratio for different portfolio allocations across varying geographic regions.
Figure 4. Average annualized Sharpe ratios for LSI and 12-month DCA portfolios, measured over rolling 12-month periods in each market.
Overall, to be comfortable with either strategy, an investor must understand that historical averages are just a guide—LSI or DCA can underperform or even lose money at any time. If an investor is concerned about the risks associated with a particular market entry strategy, it may indicate a low willingness to take risks in general. If this is the case, we suggest revisiting the target asset allocation here to ensure that it adequately meets risk tolerance levels and investing objectives.
Can anyone be successful and continually time the market?
Every investor’s dream is to have a crystal ball that can foresee the future of the stock market.
We all know that the stock market is cyclical in nature — for every bull-market, a bear-market follows. Recently, you may have seen numerous articles or news broadcasts stating something along the lines of “All Ordinaries hits new record high” or “ASX in five-day winning streak”. So, you might be thinking, “Why would I invest my money now when I could instead wait until the next downturn and invest all my money at the bottom?” While simple in theory, the problem with this thinking is that investors cannot predict the future. If markets continue to rise, by not investing now, you will have left gains on the table. Furthermore, when markets do fall at some time in the future, how will you know when it is time to buy in? In fact, Vanguard’s founder, John Bogle, famously stated that “after nearly fifty years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.”
One of the most successful investors in recent history, Peter Lynch, has also explained that “far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves”. Therefore, instead of trying to anticipate the direction of the market in order to determine the best time to invest, investors should put their money in the market as soon as possible.
Interestingly, most of the market’s returns come in a relatively small number of trading days, so by not being invested in the market, an investor will miss out on these returns. Figure 5 illustrates the detrimental effect trying to time the market can have on stock returns. Further, the below returns are irrespective of potential trading costs as well as capital gains tax implications incurred from the frequent buying and selling of securities.
Figure 5. The annualised returns for missing varying days in the market.
Despite all this, there is a form of market timing advocated by Warren Buffett that focus on timing the market based on the value of individual companies rather than the overall direction of the respective market index. That is, after a market crash, investors should seek out undervalued companies with solid fundamentals that will succeed post-crash. This strategy was employed by many diligent investors during the March 2020 lows.
Why we should not discard Dollar-Cost Averaging
There is a notable distinction between the case of lump-sum investing an immediately available sum of money as opposed to DCA in the sense of consistent investments made using current income. For instance, an employee paying a proportion of each paycheck into a superannuation fund. In this example, the investable cash becomes available periodically over time, eliminating the opportunity cost of holding cash, resulting in DCA being a prudent and effective way to invest.
If your anxiety and fear are preventing you from investing in the market, then dollar-cost averaging, although statistically suboptimal, is a much better approach than waiting for the ‘perfect time’ to invest.
Useful Investing Resources
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Karl Hemmings is a Research Analyst for UNIT (University of Melbourne), whose work primarily focuses on the intricacies of investing.
Alyssa Ng is a Research Analyst for UNIT (University of Melbourne), whose work primarily focuses on investing and macroeconomic drivers of financial markets.