Dollar-Cost Averaging vs Lump-Sum Investing Round 1: Raw Returns

published by:
October 8, 2020
dollar cost averaging

Dollar-Cost Averaging vs Lump-Sum Investing

Good news – you have an extra $24,000, and you’ve decided to invest it in the stock market. It’s always nice to have investable cash on hand. But you also might feel as if the pressure is on. Nobody enjoys seeing the market dive shortly after they jump in. Unfortunately, we never know when it might do exactly that. 

What’s an investor to do? Should you go ahead and invest the entire amount right away, or should you invest gradually, such as in 12 monthly installments? 

In financial jargon, this is known as lump-sum investing (all at once) vs. dollar-cost averaging (over time). In more approachable terms, it’s often described as “plunging” vs. “wading” into the deep end of the market. 

Which one should you use? In terms of raw expected returns, lump-sum investing is preferred. But sometimes, there are equally valid, if less tangible reasons to favor dollar-cost averaging. In this two-part series, we’ll explore both possibilities. 

Round One: Raw Returns 

In a match-up against lump-sum investing vs. dollar-cost averaging, which is the better bet? Everyone from academics to financial practitioners, to the financial press has weighed in on the matter and have reached a consistent conclusion: 

Lump-sum investing generally improves your odds of earning higher returns compared to dollar-cost averaging. 

For example: 

·        Keisha invests $24,000 as a lump sum in a low-cost, total market index fund on January 1. 

·        Kevin uses dollar-cost averaging to invest $2,000 per month for one year in the same fund, beginning on the same date. 

·        They both let the results ride from January 1 through the next 15 years. 

Who is more likely (although not guaranteed) to come out ahead? Keisha’s lump sum has a better chance of generating more wealth than Kevin’s dollar-cost averaging. 

This general expectation is well-established in academia, at least as far back as a landmark study published by George Constantinides in a 1979 Journal of Financial and Qualitative Analysis. Others have expanded on the theme ever since, examining nuances such as:

·        Do the results still hold using more current data and across various markets?

·        Does the advantage disappear after accounting for risk-related returns? 

·        Might a hybrid strategy (blending both concepts) generate even better results? 

So far, our general rule of thumb holds. Even without academic analysis, this makes sense:

1. When markets rise, lump-sum investing bests dollar-cost averaging: If you invest everything up front, more of your money has more time to compound in a rising market than if you’ve dripped it in more slowly. Of course, the reverse is also true. If markets go down, your bigger, earlier stake takes a bigger hit. But …

2. Overall and over time, markets go up higher and more often than they go down: For example, in this short, but powerful video, Dimensional Fund Advisors shows us that U.S. stock market highs and lows have varied widely in any given year. But despite setbacks along the way, the market has prevailed and delivered a healthy 10% per year on average from 1926–2019.

3. Therefore, it stands to reason: If lump-sum investing outperforms dollar-cost averaging in up markets, and markets go up more, and more often than they go down …

When the choice is available, a purely rational investor should generally prefer lump-sum investing to dollar-cost averaging. 

That said, we humans love to wonder whether generalities apply to us. What if you are not yet convinced a lump-sum investment makes sense for you, your personal circumstances, and the latest market conditions? 

This brings us to round two of our match-up between lump-sum investing vs. dollar-cost averaging. We’ll share those results soon. The winner has yet to be declared.  

Have questions about your personal financial situation? Please contact us to discuss.

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