In some ways they are diametrically opposed concepts, Increasing your time in the market and dollar cost averaging. In others they go hand in hand. Today we’ll explore which is better, lump sum investing or dollar cost averaging.
So What is Dollar Cost Averaging?
Dollar cost averaging is a type of investing where you spread your investments out over time. So imagine an example where you inherited $50,000. If you dollar cost averaged you might put $10,000 in the market every 2 months until the full $50,000 dollars is invested.
What is Lump Sum Investing?
Lump sum investing meanwhile is where you invest the full $50,000 at once. So the day after the hypothetical inheritance you call your brokerage and invest all $50K in the market.
On the surface the dollar cost averaging process sounds like it would net a higher return. You spread your money out investing when the market dips or rises, averaging out to a potentially lower purchase price. The problem with this assumption is it’s not true. A study in 2011 showed that dollar cost averaging returns lag lump sum investing nearly 2/3 of the time. Numerous other studies agree.
Assumptions About Dollar Cost Averaging
The biggest reasons are in the assumptions that make us believe dollar cost averaging is good. We assume that in a falling market we will receive some items at a lower price which will decrease our losses. The problem though, as always with an analysis, are the assumptions themselves. Sure the market has dips, but overall it trends upward. What this means is the general trend of the market is the opposite of the scenario where Dollar Cost Averaging would be beneficial. For this reason lump sum investing has the superior return in a purely mathematical sense due to time in the market.
Not All About Math
But…As I have always stated we are not purely mathematical beings, we are irrational humans. As such the Dollar Cost Averaging solution may still have some value. This potential is three fold.
First it can reduce your losses in a down market. That reduction in losses in the 1/3 scenario where dollar cost averaging sneaks ahead may be worth the cost the rest of the time depending on your disposition. Not everyone has the stomach for massive market changes. Any potential action that might allow them to stomach a downturn instead of selling low might be worth surrendering some return.
Second it can have a psychological impact. Remember our minds our wired to weigh loss aversion more heavily then gains. As such even if your overall portfolio would have higher returns over the period with lump sum, you may sleep better at night knowing there was a specific portion of funds you “did not lose”. You’d still be behind. In fact it would be completely irrational due to the fungibility of money. But again if it keeps you from doing something stupid it might be worth it.
Dollar Cost Averaging Comes Naturally
Third it can drive you to save and invest as we most commonly do. Many of us invest new money primarily based on our paycheck. If you were to invest it all at once you likely could only do so if you held the money on the sidelines. The problem is doing so defeats the very reason lump sum beats dollar cost averaging. Time in the market is the true superior investment strategy in a market that trends upward. The sooner you invest your money the better off you will statistically be.
In case of someone investing their income, putting a small part of each paycheck into the market beats saving that paycheck to the end of the year for time in the market. That is the way you should invest most of the time. If you do invest this way most of the time it’s only natural that investing a surprise amount like an inheritance would be easier to handle in the same way as your normal investing.
Dollar Cost Averaging Can Be a Slippery Slope to Market Timing
But, this still raises some interesting questions. The first of these is how do we avoid going from dollar cost averaging or even lump sum investing to timing the market. This is a very real concern with both approaches. If you hold off investing the lump sum immediately or modify the dollar cost averaging arbitrarily your most likely going to perform poorly. Time and again studies have shown we are our own worst enemies for market return.
So what is the answer to the question of avoiding timing the market? Simple, regardless of the path you choose capture in your investment plan how you will do so. Then hold your self to it. Whether that be dollar cost averaging an amount every 2 months as in my example introducing the concept or investing the money the day you get the check as in my lump sum investing example. Either of these will potentially be superior to trying to figure it out on the fly.
Asset Allocation is Disrupted by Dollar Cost Averaging
The second question is, if dollar cost averaging can mitigate some risk at the expense of returns and so can asset allocation, which is the better mitigation strategy? Well this is where things get interesting as fundamentally dollar cost averaging changes your allocation. For some period of time you will have more cash sitting outside the market than your allocation typically pretends, awaiting it’s time to invest. What that means is at each point along the DCA process until fully invested you will be sitting at a lower risk allocation then intended.
Asset Allocation as the Superior Choice
One could argue rather than using a moving target for your asset allocation you should just set it to the optimal point for your risk tolerance once and keep it there. A moving target asset allocation indicates market timing, not asset allocation. After all either your risk tolerance supports your risky asset allocation or it does not. The upper bound of risky asset allocation you can tolerate should not change from day to day due to market forces or new money. Instead only significant structural changes in your risk planning should lead to such a change.
For maximum returns you want to set your asset allocation at the upper bound of risky assets your risk tolerance supports provided you can cover your short term needs. DCA fundamentally reduces that allocation below this point for some period of time until everything is invested. As such it can never be truly optimal for your situation. As such at least mathematically I would recommend keeping your asset allocation appropriately set will always be the better approach.
Psychology Still Trumps Efficiency
Of course, I must add a disclaimer that YMMV depending on your ability to look at your money as a whole rather than just looking at your windfall. As we stated psychology is not necessarily rationale and neither are we. If you invest the windfall in one go and the risky part drops 50% of its value how will you react? Will it be the same way as if your overall portfolio drops 30%? Will you see the overall portfolio move or only the windfall you invested? That’s a question only you can answer.
Do you prefer dollar cost averaging or lump sum investing?