Dollar-cost averaging versus lump-sum investing
There may come a time when you have some money to invest, a decent sum of money.
So, what is better?
Dollar-cost averaging (DCA) versus lump-sum investing (LSI)?
This post has your answer.
Dollar-cost averaging versus lump-sum investing
Investing is never easy. I believe that is true mainly because you tend to fight a consistent enemy in the mirror – your investing behaviour. Wild stock market swings can have a devastating effect on an investors’ portfolio if they behave inappropriately. There have been some very wild swings in the stock market – both down and up – over the last 20 years, a couple of major crashes to navigate in fact.
Source: Macrotrends – S&P 500 Historical Annual Returns
When will the next market calamity hit?
I have no idea of course and nobody else does either. However it’s important to remember based on historical lessons at least what goes down, drastically even, usually comes back up again. In fact, what goes down infrequently usually comes back up more frequently – which is precisely the point to this DCA versus LSI decision!
When you have that extra cash sitting on the sidelines it’s very easy to let hindsight bias or a fear of losing money at all impact your decisions. I know, I’ve been there too. This makes dollar-cost averaging an effective way to reduce the risk (rather your fear) of investing at the wrong time. But that’s not the best decision.
How dollar-cost averaging works
Dollar-cost averaging helps investors by spreading out investing decisions over time, ideally at pre-determined intervals. Let’s walk through an example.
Let’s assume you have $12,000 to invest at the beginning of the year, contributions to your Tax Free Savings Account (TFSA) for you and your spouse.
Rather than invest it as a lump sum, $6,000 to each account, you decide to dollar-cost average instead. You know getting your money to work in the market is important, but you feel better to spread it out, so you decide to invest $1,000 to each account on the 1st day of the month for six months until all TFSA contributions are made. Through dollar-cost averaging, you can sleep better at night knowing you will be investing at different times over the coming months to smooth out stock market volatility.
But it’s usually the wrong decision.
I’ve leveraged this calculator for illustration purposes, using U.S. stock market data.
While DCA decisions can make great sense for investors who are usually spooked by a market downturn, and all the investing anxiety that comes with that decision, the reality is it’s usually better to invest all the money at once, at least two-thirds of the time.
So, if you ever find yourself receiving a cheque for a large sum of money; you have a year-end bonus from work; you have an inheritance, investing the money at once is usually the better decision.
Why lump-sum investing (LSI) works
There is a great deal of evidence to suggest that investing money right away, beyond a blogger’s calculator above, is usually best. Here is one of my favourites:
In 2020, Nick Maggiulli, Ritholtz Wealth Management’s chief operating officer, compared the performance of investing in the S&P 500 Index using a lump sum versus 24 consecutive monthly DCA contributions. Going back to 1997, he discovered that lump-sum investing produced higher returns 78% of the time with an average market outperformance of 5%. He found similar results using other markets and asset classes.
“The longer you wait, the worse off you will be, on average. The data I will present later in this post will illustrate this clearly. It’s like the saying goes:
The best time to start was yesterday. The next best time is today.
If you grasp this concept, then the rest of this post will flow much more easily.”
This only makes sense and you can see that reflected in the S&P 500 chart above. Historically, equity markets tend to go up. This means I believe, using historical data, that LSI will tend to work out better for investors that have a long-term investment timeline on their side. This means they can take advantage of any time needed to recover from a market loss if or when that happens.
Dollar-cost averaging versus lump-sum investing summary table
Ultimately, only you can decide your sleep at night factor. Personal finance is always personal.
An investor with an already substantial amount of money invested will have less reason to be anxious about dropping $6,000 (or $12,000 between partners) at once via LSI than a younger investor just starting out on their TFSA journey.
Of course, LSI vs. DCA is this context is not about a long-term, multi-year, bi-weekly or monthly approach to investing. That’s great of course. If/when you buy periodically into the market in this approach, yes, you are making small, periodic investments but you are not keeping cash lying around. You simply don’t have it.
Time in the market over timing the market
There is no one perfect way to invest cash every time. Dollar-cost averaging in this context can help reduce the impact of short-term price swings, but there’s only so much you can do to plan for a market crash.
But you simply can’t ignore the behavioural benefits of investing. So, if your gut is telling you DCA is better than LSI, it’s OK to listen near-term. Dollar-cost averaging can help investors avoid making fear-driven decisions about avoiding investing at all – which is an even bigger mistake long-term.
So, the ol’ adage is true: time in the market is better than timing the market.
Whether you choose DCA over LSI is your choice of course but the punchline remains the same: sticking to a well thought-out investing plan and consistently adding money to your portfolio should work well very over time, no matter which investing approach you choose.
“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.”
Investors: what approach works for you? Do you prefer DCA versus LSI? Do share in a comment below.