At some time or another, many investors must decide what to do with a lump sum of money — whether from a work bonus, a large tax refund or a family inheritance.
The initial inclination might be to spend this unexpected cash on that upcoming vacation or the next must-have digital device. However, if you want to invest the money into stocks, you’re left with a question: Should you put the money to work over time through what’s known as dollar-cost averaging or into the market all at once with a lump sum?
Investing a Lump Sum vs. Dollar-Cost Averaging
Many people feel more comfortable investing a little at a time with dollar-cost averaging, putting the same amount of money into stocks regularly, perhaps over a period of three, six, or even 12 months. Most often, the idea behind that approach is to mitigate the risk of a market downturn. There is a cost to this strategy, however.
Because markets trend up over time, the longer you wait to put your money to work, the greater the drag on your performance is likely to be. In addition, you may not really be protecting yourself from the risk of a downturn at all — just the risk of an immediate downturn.
It is easy to imagine the markets retreating right after you invest a lump sum. However, if you choose to dollar-cost average you may find the downturn occurs right after you have finished buying into the market, resulting in less wealth since you bought stocks at progressively higher prices over time.
When you look at the data over time, it is clear that putting your money to work sooner rather than later is a better approach.
When you look at the data over a longer sweep of time, it is clear that putting your money to work sooner rather than later is a consistently better approach.
The data paint a very clear picture. Unless you are an extraordinary investor, time in the market is going to be a more fruitful approach than timing the market. Lump-sum investing has provided consistently better returns than dollar-cost averaging for both aggressive and conservative investors.
For example, looking at every 12-month period from 1926 to mid-2014, a lump-sum investor targeting a 60 percent equity and 40 percent bond allocation would have outperformed a dollar-cost averaging approach nearly 57 percent of the time, earning an average return of 9.75 percent for the average 12-month period.
In contrast, adopting a three, six, or 12-month dollar-cost averaging approach would have resulted in average gains of 8.85 percent, 7.61 percent and 5.17 percent, respectively.
The difference between putting money to work all at once and putting it to work over 12 months is 4.58 percent, a meaningful difference which will compound (in absolute dollars) over time.
It is true that, for the investor in the previous example, the absolute worst 12-month return happened by following a lump-sum approach: -42 percent versus -32 percent for dollar-cost averaging. On the other hand, the best 12-month experience for lump sum investing, 103 percent, far exceeded the best return from dollar-cost averaging over the same time period (44 percent).
Overall, across the entire period from 1926, the percentage of times that dollar-cost averaging provided meaningful protection for a portfolio was quite small compared to the number of times it provided a meaningful drag to portfolio performance. And while dollar-cost averaging helped protect some capital in a small percentage of extreme cases, it didn’t protect investors from negative returns to any greater degree than lump-sum investing.
Automatic Investing vs. Dollar-Cost Averaging
Dollar-cost averaging is sometimes confused with automatic investing programs such as monthly paycheck withdrawals to your 401(k). The advice to put your money to work in a lump sum rather than average it into the market slowly should not be construed as advice not to engage in systematically putting money into a retirement or other investment program. Such automatic plans are a great discipline that can help ensure funds are being set aside for retirement.
But, discipline aside, if you can afford to max out your 401(k) or IRA contributions in February of each year rather than contributing smaller amounts throughout the year, you are likely to end up with more money at retirement.
Framing Investment Alternatives
The decision to dollar-cost average into the market rather than invest a lump sum of money is often framed as a choice that can help protect you from large losses. In a limited sense, that is true and it has a great psychological appeal.
However, if the decision to dollar-cost average was framed as a choice that was designed to protect you from large gains, you might have a different response! The reality is that both sides of the argument are true: sitting in cash limits both your gains and your losses.
In a certain sense, the decision to dollar-cost average can be viewed as “buying insurance” against a potentially bad outcome by foregoing some investment return. The question you should be asking: “Is the price of this ‘insurance’ too high (for me) or are there better ways to protect my wealth?”
This is where a good financial adviser can help frame probabilities and potential outcomes for you to ensure that you are considering both risk and return in your investment decisions and formulating a plan you can stick with through volatile markets.
We used historical data from the S&P 500 Index as a proxy for equity returns, and a split of the Ibbotson Intermediate Term Government and Ibbotson Long Term Corporate indexes as a proxy for bond returns. To simplify the analysis, we assumed a return of 0 percent on money not yet invested in equities or bonds by someone engaged in dollar-cost averaging. The illustration above does not reflect investment fees or transactions costs.