Question from our GenYmoney Facebook group: I recently got into index investing. I am not sure whether the payoff is better if I contribute a monthly amount (dollar-cost averaging) or a yearly lump sum, in this situation. Please advise.
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Ben Felix provides one-on-one financial advice sessions about investing, insurance, financial planning, and anything else personal finance related.
Benjamin Felix is an investment adviser with PWL Capital in Ottawa.
Answer: Not everyone has a pile of money to invest, but those who do are faced with an important decision: Do you invest in a lump sum today, or enter the market gradually?
Dollar-cost averaging (DCA) is a popular strategy in the world of personal finance. If you aren’t familiar with the term, it means investing fixed amounts over time. For example, if you have $100,000 available, you might choose to invest $10,000 per month over the course of 10 months instead of investing the full $100,000 immediately.
The strategy sounds very attractive to most people. With DCA, you don’t run the risk of investing all of your money right before a market decline; if there is a decline, you might be buying cheap assets with some of your remaining cash. Another way of looking at it is that with DCA you are buying fewer shares when assets are expensive, and more shares when assets are cheap. Seems like a bulletproof strategy when the alternative can feel like a gamble (is now the right time to invest?) – we know that timing the market is a losing game, making DCA appear even more attractive.
It’s hard to argue with the data. DCA has a great story to tell, but like many things in personal finance, the data disagree with the common discourse. The two alternatives, DCA and lump-sum investing, have been studied at length over the years, and the research has consistently shown that DCA usually results in lower long-term returns.
A 2012 Vanguard white paper titled “Dollar-cost averaging just means taking risk later” compared the historical performance of DCA with lump-sum investing across the U.S., U.K., and Australian stock markets. They examined rolling 10-year periods from the beginning of each data series through the end of 2011. Across all markets examined, investing a lump sum outperformed DCA about two-thirds of the time. This conclusion makes logical sense. Stocks have higher expected returns than cash, so owning more stocks sooner results in higher expected returns compared with gradually transitioning from cash to stocks.
There is little room to argue. DCA does not give you the expectation of a better long-term outcome. Statistically, you are better off investing the lump sum.
And there’s more to it than statistics Maximizing expected returns is not always the primary concern. If you do invest a lump sum immediately preceding a market crash, you may feel severe feelings of regret. If you had invested $100,000 in March, 2008, you would have been left with only $59,400 by February, 2009. Think about how that might have felt before dumping all of your money into the market today. At the same time, even if you had invested lump sums at some of the worst possible times in recent history, your long-term outcome would have still been pretty good if you had managed to stayed invested.
If you don’t have a pile of money to invest today, DCA is better than waiting until you have saved up a lump sum to invest – the sooner that you can have your money invested in a risk-appropriate portfolio, the better. If you do have a pile of money to invest, the most important decision point is emotional. If market turbulence won’t keep you up at night, then investing your lump sum is likely to deliver higher long-term returns.
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