Dollar-Cost Averaging vs. Lump-Sum Investing

Matt Stucky is the chief portfolio manager at Northwestern Mutual Wealth Management Company.

If you find yourself with a sudden windfall—like a large bonus or inheritance—you’ll inevitably encounter one of investing’s classic dilemmas: Should you invest it all immediately? Or should you invest it at regular intervals over a longer period of time through a process known as dollar-cost averaging?

Dollar-cost averaging means investing smaller amounts in a stock or fund periodically to build a position over time rather than all at once.

A frequent question we get from clients with lump sums to invest isn’t necessarily what to invest in but how they should put that money to work. People wonder whether they should invest the lump sum immediately or go with dollar-cost averaging. For most clients, the answer isn’t obvious and may require balancing historical data with your timeline and tolerance for risk.

Below, we take a closer look at both strategies, including how both have performed historically, and we offer guidance to help you determine which is right for you.

Is dollar-cost averaging better than lump-sum investing?

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 out 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 everyone. Here’s why.

Comparing lump-sum investing with dollar-cost averaging

To determine which strategy performed best in terms of return, Northwestern Mutual’s research team analyzed rolling 10-year returns of $1 million invested immediately in the U.S. markets vs. dollar-cost averaging. In the dollar-cost averaging scenario, the money is invested evenly over 12 months and then held for the remaining nine years.

The team tested both strategies in a few portfolio designs:

• 100 percent equities
• A 60/40 split between equities and fixed income
• 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).

The data shows 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, a 60/40 allocation at 80 percent, and all equity at 75 percent. The difference in performance held whether a portfolio was invested in all stocks or all bonds and everything in between.

How lump-sum investing outperformed dollar-cost averaging

This happens because of 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 than does cash, 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 vs. a dollar-cost averaging implementation. So, over time it generates better outcomes.

The table below shows the distribution of the historical cumulative total return difference and outperformance probability between lump-sum investing and dollar-cost averaging 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 the other strategy.

Essentially, the data supports this adage: Time in the market beats timing the market. Investing a windfall immediately allows an investor to capture returns with all of their capital at the outset vs. the 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. And the data overwhelmingly shows 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 return.

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 during the implementation phase.

Considering only historical data when making this investing decision ignores the behavioral and emotional side of investing. 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 of each paycheck going toward retirement. If you contribute to an employer-sponsored retirement plan like a 401(k) or 403(b), 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, waiting for a “good” time to invest. Again, it’s advantageous to be in markets sooner than it is to wait because historical data shows 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 shows 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. 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 talk 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.