A very common question that gets raised in the investing community is whether it is better to dollar-cost average (DCA) or invest in lump sums. Today, I’m going to cover both of these theories to help you decide which method is better for you – DCA vs Lump-sum Investing.
People who have accumulated considerable savings have recently sold a house or business or who have received inheritance may come across a situation where they have a large sum of money to invest. If you are one of these people, you will be faced with the dilemma of whether to invest your sum all at once or to invest it in smaller chunks over a longer time period.
On paper, lump-sum investing will typically yield a greater result. The reason that this strategy works more often than not, is that the market will typically grow in value each. However, with the stock market being forever volatile, the fear of a market correction or recession occurring directly after a person invests their lump sum can often deter people from this strategy.
Vanguard Total International Stock Index Fund Investor Shares (VGTSX) is an index fund that has more than 6,000 different holdings spread across the globe. Due to their diverse spread, I am using them as an example of how not just the Australian or US market performs but how the majority of markets perform over a long period.
Over a 24 year period, VGTSX has 9 negative returns which equate to a 37.5% chance that lump sum investing directly before these years would have yielded poorer results than dollar-cost averaging. However, 15 of these years or 62.5% of the time, you would have grown your wealth faster utilising lump-sum investing. Using DCA during these periods would mean that you were gradually paying more for the same amount of shares.
Based on these stats, and similar stats found from other index funds, lump-sum investing is statistically more likely to yield you greater results, as you avoid constantly purchasing shares during a growth period. However, this can be a hard approach to stick with, due to a thing called analysis paralysis. Analysis paralysis is where people become so fixated on trying to anticipate market fluctuations that they avoid investing altogether because they are adamant that the market will continuously drop.
Ultimately, this boils down to timing the market which is something that is impossible for professional investors and fund managers to accurately predict on a frequent basis. If these financial experts can’t predict it with all the time, tools and information that they dedicate to speculating, the chance of you or I being able to do it is nigh impossible. For that reason, lump-sum investing is often the most likely investing option to yield greater long term results.
After reading the above data, it may seem reasonable to simply save up a large sum of money to invest in one hit. While this appears sound on paper, there’s a distinct difference between investing a lump sum that you unexpectantly received and saving up a lump sum with the intention to invest.
While lump-sum investing will typically work better for people who have recently inherited a lump sum, this is very different to someone who is diverting their regular investments to horde cash in hopes of there being a recession where they can buy everything ‘on special’.
Currently in Australia, if you hold your money in the highest interest savings account available, you will be losing money when factoring in inflation and tax (unless you’re making below $18,200 per year). Subsequently, hoarding money into savings accounts for a long period of time to try and time the market will often yield poor results.
When your money is sitting in a savings account that yields interest below that of inflation, you are slowly losing your money. If you factor in that most years, the market grows in value as opposed to decreasing in value, then you can lose money in your savings account while missing out on the potential gains from the market increasing during your withholding period.
For these reasons, I personally prefer to DCA if I do not have an unexpected lump sum inbound, as timing the market is impossible to do with certainty and the opportunity cost of withholding money as opposed to investing it far outweighs the potential for being able to accurately time a recession or market correction.
DCA occurs when you divide your large sum into smaller sums that get invested routinely in even amounts at even time periods. This can be used as a hedging method as by investing continuously throughout the year, you are spreading the purchase price of each share. If the market is on a decline, this means that you will continuously purchase shares at a lower price each time. Alternatively, if the market is on an incline, you will continuously be purchasing shares at a higher price each time.
Because you are averaging out the purchase price of shares through DCA, it is psychologically a more reassuring investment method, as you will be impacted less severely during recessions and market corrections. However, this psychological benefit can often come at the expense of potential financial gains as the above stats illustrate that more often than not, the market will grow in any given year.
Another important thing to note is that most investors who do not have a lump sum acquired from selling a house, business or receiving an inheritance will be doing DCA unintentionally by investing at intervals where they acquire enough cash to warrant the brokerage fee of purchasing shares. This is often around $2,500 – $5,000 depending on who you ask and what your brokerage fees are.
Brokerage fees can make or break a DCA strategy. Poorly planning your investing schedule can result in brokerage fees taking a significant percentage of your future gains. For example, if you invest $100 with a $10 brokerage fee, you’re already down 10% from your initial investment, as only $90 has gone to the asset that you purchased. Similarly, if you invest $1,000 with the same fee, you will be down 1% from your initial investment, which can also be considered high. Contrast this with a $10,000 investment and you are only down 0.1%.
For these reasons, it is important to identify a DCA strategy where you invest an appropriate sum of money to prevent brokerage fees from detracting from your financial returns. If you are just starting off or are unsure on the optimal frequency, this handy calculator can provide a reliable metric for identifying your optimal investing frequency based on your personal circumstances:
Lump-sum investing when you have recently received a large sum of money will more often than not be more effective than DCA. However, while lump-sum investing in this circumstance is typically the better option, DCA can offer more peace of mind by hedging against unexpected market corrections and recessions, albeit at the potential expense of your growth returns.
For people who do not have large sums of money readily available to invest, DCA will typically offer greater results, as time in the market is better than timing the market. By withholding your regular investments to accumulate a lump sum, the opportunity cost of doing so combined with the impossibility of timing the market makes this an often detrimental strategy. Therefore, I personally use the following two options:
Recently Acquired a Lump Sum? Use lump-sum investing
No Current Lump Sum? Use DCA
If you would like to learn more about investing in particular assets, I recommend the following articles: