Is Dollar-Cost Averaging Better Than Lump-Sum Investing?
If you find yourself the beneficiary of a sudden windfall, you’ll inevitably encounter a classic investing dilemma: Invest it all immediately, or invest it at regular intervals over a longer period of time; known as dollar-cost averaging?
“A frequent question we receive from clients with lump sums to invest isn’t necessarily what to invest in but rather how should they put that money to work?” says Matt Wilbur, senior director of advisory investments at Northwestern Mutual. “Should you invest the lump sum immediately, or is dollar-cost averaging a better way into the market? For most clients, the answer isn’t obvious and may require balancing historical data with your tolerance for risk.”
One school of thought holds that investing a lump sum of money puts it to work in markets immediately to capture growth potential, rather than letting inflation erode its purchasing power as it sits as cash on the sidelines. Another school of thought holds that dollar-cost averaging helps you glide into a better average price per share and smooth the effects of market volatility.
It’s not an easy decision, especially when you’re talking about a large sum of money.
Our research team took a stab at solving this dilemma from a purely return standpoint, and investing a lump sum all at once outperformed dollar-cost averaging, by far. But that doesn’t necessarily make it a better strategy for you. Here’s why.
Comparing lump-sum investing with dollar-cost averaging
To determine which strategy performed best in terms of performance, NM’s research team analyzed rolling, 10-year returns of $1 million invested immediately in the U.S. markets, versus dollar-cost averaging. In the dollar-cost averaging scenario, the money is invested evenly over 12 months and then held for the remaining 9 years.
The team tested both strategies in a few portfolio designs (100 percent equities, a 60/40 split between equities and fixed income and 100 percent fixed income.) Using 10-year return data, rolled monthly, the charts show the historical disparity in performance between lump-sum investing (LSI) and dollar-cost averaging (DCA).
How lump-sum investing outperformed dollar-cost averaging
The data show that investing a $1 million windfall all at once generated better cumulative total returns at the end of 10 years than dollar-cost averaging almost 75 percent of the time, regardless of asset allocation (a 100 percent fixed income portfolio outperformed dollar-cost averaging 90 percent of the time with a 60/40 at 80 percent, all equity at 75 percent). The disparity in performance held whether a portfolio was invested in all stocks or all bonds, and everything in between.
Why does this happen? It’s simply the long-term relationship between risk and return. Stocks are riskier than bonds, which are riskier than cash equivalents. This higher level of risk demands a higher expected return over cash and so a diversified portfolio that holds more stocks and bonds instead of cash has a higher expected return. A lump-sum investment implementation holds less cash over the life of the study versus a dollar-cost averaging implementation. Therefore, over time it generates superior returns.
The table below shows the distribution of the historical cumulative total return difference and outperformance probability between and LSI and DCA implementation over the 10-year analysis period. Observations where lump-sum investing outperforms are associated with markets that trended higher over time while dollar-cost averaging outperformed when the implementation occurred during markets that were trending lower. Historically, there are more years where markets trend higher, which also leads to lump-sum investing outperforming.
Essentially, the data support the adage: Time in the market beats timing the market. Investing that windfall immediately allows an investor to capture returns with all of their capital at the outset versus a spread-out approach that dollar-cost averaging utilizes.
“Having a plan and letting data guide your decision making is the best way to be positioned for success in investing” says Matt Stucky, senior portfolio manager at Northwestern Mutual. “The data overwhelmingly show that diversified portfolios generate strong results for investors over the long term and that market timing or sitting on excess cash costs investors significant performance.”
When is dollar-cost averaging better than lump-sum investing?
Dollar-cost averaging would seem to be an inferior strategy for investing a windfall, but let’s not count the strategy out yet. That’s because performance is just one of many factors an investor should consider before putting money to work in markets. For starters, your stress levels and emotional well-being are just as important as your portfolio’s performance.
All the numbers and historical data in the world won’t make it feel any better to see a large sum of money decline 10,15, 20 percent or more in value in a short period of time. If the markets make you nervous and you aren’t entirely comfortable putting your windfall at risk, dollar-cost averaging can be a good way to participate in markets at your comfort level, smoothing out the ups and downs.
“Considering only historical data when making this investing decision ignores the behavioral and emotional side of investing,” says Wilbur. “For example, if you unexpectedly inherit a large sum from a loved one, feelings of sadness, anger, guilt, great responsibility, and other emotions can overwhelm the decision-making process. In that case, dollar-cost averaging might be a more comfortable way to take investing action.”
Keep in mind, this analysis focuses specifically on investing a large sum of money now or later. Dollar-cost averaging remains a solid strategy for consistently investing small amounts of money — like a portion from each paycheck going toward retirement. If you contribute to an employer-sponsored retirement plan, you are already dollar-cost averaging each time you’re paid.
Dollar-cost averaging small amounts tends to be a better strategy than saving and accumulating cash and waiting for a “good” time to invest. Again, it’s advantageous to be in markets sooner than it is to wait, because historical data show investors (even professional investors) aren’t that good at timing markets. Dollar-cost averaging ensures a small amount of cash that's coming in the door is immediately invested in markets to capture potential long-term upside.
Choosing dollar-cost averaging vs. lump sum investing
If you’re purely focused on performance and can stomach a little volatility, data show investing a lump sum as soon as you can (regardless of where markets are) tends to breed outperformance over long time periods. Still, if markets make you nervous, it is much better to dollar-cost average and acquaint yourself with market risk over time rather than avoid markets altogether.
“We consistently see cash as being one of the lowest returning asset classes in our nine asset class portfolios over the long term,” says Stucky. “Whatever process helps you to implement your portfolio strategy as recommended by your financial plan, it’ll likely be vastly superior to maintaining high cash balances.”
Ultimately, financial planning aims to strike a balance between performance, your goals, and your tolerance for risk. It’s a highly personal endeavor, which means there are no hard and fast rules. If you’re fortunate to be on the receiving end of a sizable windfall, it makes a lot of sense to speak with a financial advisor to strategically manage those funds in a way that works best for you.
Hypothetical analysis for illustration purposes only assumes equity and bond allocations in the three portfolios (all equities, 60/40 equities to bonds, and 100 percent bonds) are invested in an "all-market" U.S. equities or U.S. bond index. For the LSI method, all $1 million is invested on day one and held for 10 years. For the DCA method, 1/12th of $1 million is invested each month for 12 months and then held for the remaining nine years. This index is unmanaged and cannot be invested in directly. Rolling returns, also known as "rolling period returns" or "rolling time periods," are annualized average returns for a period, ending with the listed year.
All investments carry some level of risk including the potential loss of all money invested. Past performance is no guarantee of future performance. No investment strategy can guarantee a profit or protect against a loss.