Choosing Between Dollar-Cost Averaging and Lump-Sum Investing
Vineel Bhat | 12/10/21
Introduction
2 of the most popular methods for investing are dollar-cost averaging and lump-sum investing. Here, we break down these methods, dive deep into their relative performance over the past 150 years, and come to a conclusion on which to choose.
Dollar-Cost Averaging Overview
Dollar-cost averaging (DCA) is an investment strategy in which money is set aside to be invested periodically. For example, instead of investing a hypothetical $5,000 bonus right away, dollar-cost averaging could mean investing $500 every month over the next 10 months. The DCA strategy aims to reduce volatility, but may also allow for the purchase of an asset at a lower average cost if price movement happens to be sour.
Looking at a more in-depth example, let’s say you have $1,200 ready to invest. Instead of investing all cash into an S&P 500 index fund at once, you dollar-cost average by investing $100 every month for 12 months, adding up to $1,200 in total. The share price which is initially at $20 goes up to 33, then down to 5 for a while, and finally up to $50 by the end of the year. Because you invest the fixed amount of $100 every month, the number of shares you buy differs based on the share price. When the share price is $20, you buy 5 shares. When the price goes up to $25, you only buy 4 shares. At 33 you buy 3 shares, at $20 you buy 5 shares, at $10 you buy 10 shares, and at $5 you buy 20 shares for 3 months. When the price goes to $10 you buy 10 shares again, then 5 shares, 4 shares, and lastly 2 shares in December when the share price hits $50.
Source: Invessential.com
The average share price was $19 a share. However, the average price you paid was $11: because you invested a fixed $100 every month, you bought more shares when prices were low and fewer shares when prices were high. Keep in mind that dollar-cost averaging doesn’t always work in your favor; the numbers presented here were purely for example.
Lump-Sum Investing Overview
Lump-sum investing (LS) is an investment strategy in which money is invested all at once. For example, instead of investing a hypothetical $500 every month over the next 10 months (dollar-cost averaging [DCA]), lump-sum investing would mean investing $5000 right away. Compared to DCA which aims to reduce volatility, the LS strategy aims to maximize gains.
Going back to the previous example, let’s say you have $1,200 ready to invest. This time, instead of investing $100 every month for 12 months, you lump-sum by investing all $1,200 into an S&P 500 index fund at once. The share price is initially $20, so you purchase 60 shares with all your cash. You make no additional purchases throughout the year.
Source: Invessential.com
With the same numbers, the average share price was still $19 a share. However, the average price you paid was $20: because you invested everything at the initial price, you missed opportunities to purchase shares are lower prices. Keep in mind that lump-sum investing sometimes works in your favor; the numbers presented here were purely for example.
The Decisive Comparison: Performance
Choosing between lump-sum investing and DCA primarily comes down to performance. I spent the past couple days analyzing Yale economist Robert Shiller’s historical data on the S&P 500 since 1871 (available online here, all prices were adjusted for dividend reinvestment) to understand 1) how often one strategy outperforms the other and 2) by how much. The numbers for 1) are summarized in the figure below:
Source: Invessential.com
Defining lump-sum as investing a sum of money all at once into the S&P 500, and DCA as investing the same sum of money evenly over 12 months, lump-sum investing outperforms DCA ~70% of the time over practically any length of time.
This makes logical sense too – since the market goes up more often than it goes down. Investing money all at once allows you to take part in bull runs that would otherwise not be fully capitalized on with dollar-cost averaging.
Moving to 2), although lump-sum outperforms ~70% of the time, the outperformance isn’t strikingly large.
| Metric | 1 year | 3 years | 5 years | 10 years | 20 years | 40 years | 60 years | 80 years | 100 years | 120 years |
|---|---|---|---|---|---|---|---|---|---|---|
|
Avg. LS Outperformance (CAGR) |
5.17% |
1.62% |
0.96% |
0.47% |
0.23% |
0.11% |
0.06% |
0.03% |
0.04% |
0.04% |
|
Avg. LS Outperformance (Total) |
4.89% |
4.54% |
4.47% |
4.36% |
4.19% |
4.09% |
3.58% |
2.49% |
3.40% |
4.02% |
Over a time frame of 1 year, lump-sum investing crushes DCA by a CAGR of over 5% on average, however, this number gets diluted over longer time frames. Dollar-cost averaging was defined as being over 12 months, so over a long period of time like 60 years, lump-sum and DCA would share the same gains over 59 years, causing any outperformance to be slim. When looking at a different metric (second row of the table) – the total percent more money you would have made with LS over DCA on average – it’s ~4% for nearly every time period. This can be interpreted as the following: by having chosen to invest all at once rather than DCA’ing in the past, you would – on average – have had 4% more money at any point in time.
Ultimately, it’s safe to say that lump-sum outperforms DCA most of the time, but by a relatively small amount.
Other Considerations
Psychologically, dollar-cost averaging feels like the “safer” approach because the market is so unpredictable: by investing in small chunks over a period of time, your overall portfolio becomes less volatile since you’re not fully invested, and if there’s a decline in asset prices, you have dry powder to capitalize on the situation.
Choosing between lump-sum and dollar-cost averaging can be viewed as a choice between higher risk higher return and lower risk lower return. The longer you DCA for, the higher the underperformance. The stats above showed that over 12 months, lump-sum has only led to a 4% increase on average in the amount of money you would have had at any point in time. If you were to dollar-cost average over just a period of 30 days, the performance difference would close in to nearly zero, but if you were to dollar-cost average over a period like 10 years (meaning you would keep some money uninvested for nearly a decade!), dollar-cost averaging would underperform severely.
Conclusion
For most long-term investors, lump-sum investing trumps dollar-cost averaging. Lump-sum, on average, has consistently outperformed dollar-cost averaging in the past over any time period (~70% of the time), and will likely continue to do so over the foreseeable future. Although lump-sum’s outperformance is slight on average (~4%), that can come out to a substantial sum of money after decades of compounding. DCA’ing is less volatile while you are not fully invested, but it doesn’t reduce the volatility of the underlying investment after that period of averaging in is over. For those close to retirement or who need cash in the short to mid-term, investments like CDs and treasury bonds are preferred low-risk assets. Otherwise, lump-sum investing into an S&P 500 index fund is a simple, effective path to building long-term wealth.
Cheers, and happy investing!
Code
Any code related to my posts (analysis or plotting) is available on GitHub here. Files are named based on the date of the post (e.g., 12/10/2021 for this article). For questions, feel free to contact me at invessentialmain[at]gmail[dot]com.
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Disclaimer: Opinions not advice! I am not a registered financial advisor. All views and recommendations expressed in this article are solely my opinions and should not be considered as financial advice.