Should you dollar cost average or invest your savings in a lump sum?
Looking back at my investing track record and past experiences, there’s a lot I could’ve done to get better results. Not that I’m complaining — after all, we’ve been in the midst of some major returns over the last several decades, during which I’ve been an active investor in the stock market. But it was eye-opening to put myself to the test by asking this basic question:
How would you invest a windfall?
My answer 15 years ago would have been:
- Buy into individual tech stocks at lower prices and sell them when prices peaked.
- Buy the best performing or most popular no-load funds of the previous years.
- Dollar cost average into funds over the course of a year. Buy low and hold on, as they say.
Today, my philosophy is quite different. Ask me now and I’d reply:
- Create and maintain an asset allocation that suits my risk profile and time horizon. This cool wizard helps!
- Buy index funds and index ETFs.
- Invest in a lump sum (if I happen to have a bulk of cash lying around).
In hindsight, not only would I place any large amount of investable cash in a different type of investment (index funds, rather than actively managed funds or stocks), but I would also opt to change the frequency upon which I’d invest it: by performing lump sum investing (LSI) rather than my erstwhile preferred strategy of dollar cost averaging (DCA). [Though I'd still DCA savings from an income stream.]
Before I get into detail as to why, let’s talk about the various ways we decide to enter the market.
3 Popular Investment Timing Strategies
#1 Lump Sum Investing (LSI): You invest all you have in one fell swoop.
#2 Value Cost Averaging (VCA) or Value Averaging: You invest your money gradually in the market by picking a target amount or value for your account to reach, for each time period (e.g. per month). You’ll end up adjusting the amount of money you invest each period, with bigger amounts being invested when security prices are low and smaller amounts when prices are high.
#3 Dollar Cost Averaging (DCA): Similar to VCA, this is what we commonly describe as investing with set amounts in regular fixed intervals, typically seen when we put money into our retirement accounts on an automatic schedule. You also benefit from lower market prices by ending up buying more shares as security prices go down and less shares when prices go up.
Since VCA and DCA sound similar, here’s an example that distinguishes them based on a hypothetical situation where we have shares that start out at $10, decline to a low of $6 over a few months and then go back to $10 at the end of 4 months.
Value Cost Averaging Example
|Share Price||Amount Invested||Number of Shares Bought||Target Value|
|TOTAL||$3,700||500||Total Account Value: $5,000|
Dollar Cost Averaging Example
|Share Price||Amount Invested||Number of Shares Bought||Account Value|
|TOTAL||$4,000||492||Total Account Value: $4,920|
Note that VCA involves the adjustment (and variation) of both investment amounts and number of shares bought per month, while DCA reflects fixed investment amounts with varying number of shares purchased per month. This example shows how VCA returns superior results over DCA. Something a bit odd about VCA is that if your account value grows more than your target value during a given month, you may have to determine how you would tweak your contribution. Do you refrain from buying shares then? Or do you sell your shares to meet your target value (bad for taxable accounts!), or simply readjust your target values upward? It’s really up to you, but that’s the idea behind VCA.
If you’ve complied with any of these methods over the last couple of decades, then great! You’ve done well since your money has spent some time in this generally rising market. But could you have done better? Or more importantly, which approach would you prefer to employ, all things considered?
Comparing Investing Frequency Methods
Here’s a table comparing all three approaches based on a few factors.
|Lump Sum Investing||Value Cost Averaging||Dollar Cost Averaging|
|Performance||Best in a rising market. Since the US stock market has been rising over the long term, this approach has yielded the best returns over the long term. The US stock market has risen 70% of the time.||Produces next best results, after LSI. Regular investing will allow you to commit more money and buy more shares when prices are low.||Yields the lowest returns relative to LSI and VCA. Regular investing will allow you to buy more shares when prices are low given a fixed investment schedule.|
|Convenience||Very convenient. You simply invest your entire stock market allocation in one lump sum.||Not convenient at all! Disadvantages include having to calculate periodic investment amounts, using a lot of math in the process and potentially having to fork out more money during very weak market periods. Unpredictable investment amounts per month may be a hassle. Though investing needs to be done regularly, it is not an automatic process.||Convenient. Just set up your account for automatic periodic investments. Usually, you can just invest a fixed amount per month, put it on autopilot and forget about it.|
|Psychology||Less comforting during down markets. Imagine investing in March 2000 and having to sit through ~50% losses by late 2003. Particularly hard during extended down periods.||A good strategy during down markets. Helps you resist timing the market and avoid worst case scenarios but consistency is key.||Similar to VCA. Helps you resist timing the market and avoid worst case scenarios but consistency is key.|
|Recommendation||Best strategy if you’ve got a bunch of money to invest. Choose a blend of stocks and bonds you’re comfortable with and invest outright using this allocation.||If you have the patience to invest this way, then do so. Great when you have periodic income that you can invest in regular intervals and best for those with good math skills . Like DCA, best when markets go sideways or down for an extended period (measured in years) then go back up and recover with strong upside.||Best for those with small amounts to invest, who are frightful of down markets but would still like to invest.|
I like the strategy that produces the best performance along with the most convenient set up, even if it means sacrificing a bit of my peace of mind. So if I’m ever lucky enough to receive a windfall in my future, I’d instead apply it to my existing portfolio allocation all at once, then manage the risk of this portfolio by regularly rebalancing it. To make this point, check out the following quote from this excellent article:
Rebalancing to a target asset allocation allows you to buy low and sell high. “Dollar cost averaging” is just a synonym for adopting a hyper-conservative target allocation that becomes more appropriate over a short time horizon.
Despite the best performance returns garnered with the LSI approach, there’s still a lot of psychology involved in investing such that a nervous nelly may still find it more assuring to use DCA. After all, when markets go down, many feel obliged to sell while others will hesitate to buy. You’ll need to conquer such fears in order to stay in the market and reap the benefits of being a long term investor.
Also note that lump sum investing does not beat dollar cost averaging at all times. There are times when VCA and DCA are superior to LSI. For instance, dollar cost averaging in a gold fund during 1996 – 2006 would have yielded a return of 110% while lump sum investing would have given you a gain of 82%. Over the 10 year period of 1996 to 2006, DCA performance beat LSI in the case of investments in emerging markets, the Pacific region and Japan funds. Though many articles say that difficult markets like these are rare, committing a lump sum while at the top of a bubble can be quite painful once that bubble bursts. Just ask dot com investors or those people who’ve invested huge lump sums into real estate in 2006! You’ll alleviate this pain of course, if you follow smart asset allocation strategies.
Finally, this post wouldn’t be complete without this tool that shows you the performance difference between LSI and DCA throughout the years. I’ve also enjoyed meaningful posts on this topic from My Money Blog and All Financial Matters, with the latter offering us a terrific chart showing the performance differences of these methods.
Copyright © 2008 The Digerati Life. All Rights Reserved.