Say you’ve got an extra $30,000 lying around that you want to invest. What do you do? Would you invest it all at once (lump sum investing) or spread that investment out over a period of time (dollar cost averaging)?
This is the decision we found ourselves facing about six-months ago. After making a major change to our home renovation plans that reduced the cash we would need for the project, we ended up with $30,000 extra to invest.
We went back and forth as to when and how to invest the extra money. With the volatility in the stock market, economic uncertainties, and other on-going renovation costs, we ultimately decided on a dollar cost averaging strategy.
Like many topics in the personal finance community, including the raging debate around whether you should invest or pay down mortgage debt, this is only partially a math question. Why? For the same reasons it always is. Math isn’t the only thing that comes into play when dealing with real live humans. One of the biggest obstacles in investing is our own emotions.
Additionally, while you can use assumptions based on historical market performance to calculate the “math,” no one can predict what future returns or market volatility will be.
Before we get into it, I’d like to remind you that this blog reflects my own research and opinions. Nothing in it should be taken as investment advice.
What is dollar cost averaging (“DCA”)?
Dollar cost averaging is an investment strategy where the investor divides the total investment amount into investment purchases made over a period of time.
Most people follow this approach for at least one of their investment accounts. For example, when you invest a percentage of your paycheck into a retirement plan each pay period, you are dollar-cost averaging. However, in that case, you are just investing as you earn, rather than holding on to a pile of money and deliberately trying to spread an investment out.
Benefits of dollar cost averaging
One of the primary benefits of this approach is the presumption that it reduces the risk of market volatility. If the market goes down, you can buy at a lower average price, rather than a single higher price. We’ll dive into this later in the post.
The other benefits of dollar cost averaging are related to the human psyche and less debatable. If you are risk adverse and/or would feel regretful (or, worse, panic sell) if the event of a market decline after making a big investment, than dollar cost averaging may be a better approach for you. It will provide you with a greater sense of control, which might put you more at ease. Panic selling would be the worst option.
Additionally, dollar cost averaging offers more flexibility if your plans change. If you want or need the money for something else, you can do so, since you’ve maintained some cash on the sidelines.
Having cash flow flexibility during our significant home renovation is one of the reasons we’ve been following a dollar cost averaging approach for our taxable accounts during the past two years.
Benefits of lump sum investing
Investing all of your money at once ensures that you gain exposure to the market as soon as possible. And that’s a good thing, because historical market trends show returns on equities exceed returns on cash.
Additionally, if you invest in equities that pay dividends or bonds that pay interest, you can start reaping the benefits of those passive earnings right away.
While the dollar cost averaging approach protects your investment from downside risk, investing in a lump sum protects your investment from upside risk… that is, the risk that the market increases before you get your money in and you miss out on the gains.
“The best time to invest in the market was yesterday… the second-best time is today.”
Is dollar cost averaging the same thing as timing the market?
Basically. When it applies to windfalls or large chunks of money that you have available to invest today, choosing to delay your investment, is effectively the same thing as trying to time the market. You are just deferring the risk.
What does the research say?
Most of the research I’ve seen suggests that lump sum investing beats out dollar cost averaging the majority of the time. Not all the time, but if you want to play the odds, lump sum investing is your best bet.
Vanguard published a study in 2012 that compared lump sum investing to dollar cost averaging, which found that lump sum investing beat out dollar cost averaging around two thirds of the time.
Vanguard’s study looked at how the two investment strategies would differ over various rolling ten-year periods in the United States (US), United Kingdom (UK), and Australian markets, using dollar cost averaging increments of six to 36 months.
There was little difference in results across markets, but the study did find that the lump sum investing was more likely to win out the longer the DCA period. For example, in the US market, lump sum investing beat out dollar cost averaging 90% of the time when a DCA period of 36 months was used.
The study also considered different portfolio allocations, including 100% bonds, 40% bonds/60% equities, and 100% equities. Though the differences in results based on portfolio allocation were slightly larger in the UK and Australian markets than the U.S., lump sum investing won in every case.
How much more money did the lump sum investors have? According to the study, the average ending portfolio for the lump sum approach was 2.3% higher than that of a 12-month dollar cost average period in the US. The average benefit was 2.2% in the UK and 1.3% in Australia.
So, did the dollar cost averaging strategy work for us?
Nope.
I’ll give Mr. RFL some credit on this one, since he suggested we immediately invest all (or most of) the extra $30,000. I just didn’t listen.
The market was extremely volatile and there were A LOT of “predictions” of another big dip. I wanted to keep some cash available in case there was another crash. Though there was some psychological benefit to having the flexibility of extra cash in times of uncertainty, I’ll admit that it was mostly a failed attempt to time the market.
How much $$ did we miss out on?
As mentioned above, we had an extra $30,000 to invest in October 2020. Instead of investing it all at once, we decided to invest $3,000 right away and spread the rest out over a six-month period.
Additionally, because I’m human and didn’t automate the process, I didn’t strictly follow the DCA strategy. The amounts invested each day ranged from $100 to $1,000 depending on market activity, though it did take nearly six-months to invest it all.
We also invest our monthly savings regularly in a variety of funds. However, for simplicity purposes, I will just use Vanguard Total Stock Market Index Fund (VTSAX) for comparison purposes herein, which is our primary taxable investment vehicle. Let’s assume that our other investments over that period came from current earnings saved.
The Lump Sum Option
IF we had just invested the entire $30,000 on October 13, 2020 (the first day we began investing the money), we could have purchased 344 shares of VTSAX at a price of $87.14. We also would have received and reinvested dividends on the full amount in both December 2020 and March 2021.
The closing price on April 6, 2021 was $103.06, which means our investment would have grown to $35,742, after factoring in dividends. That’s a gain of $5,742!
The Dollar Cost Averaging Option
Instead, we bled the money into the market over the six-month period and our $30,000 only bought us 316 shares, which are now worth $33,325.
The Takeaway
Well, as you can calculate from above, lump sum investing would have made us $2,417 richer than we are today. The difference of 8% is a lot higher than that found in the Vanguard study. Perhaps it was the crazy market boom we’re in, or the effects of my human tinkering with the investment amounts. Either way, you just can’t predict the future and there’s no point in trying to time the market.
I guess that saying, “Time in the market is better than timing the market” is true after all… most of the time.
Allen @ freedomJarFIRE
Interesting breakdown! I’ve seen the study and heard time & again that lump sum wins most often, but I have to say I’m with you on a bit of fear holding me back. I think I’d have donethe same thing at many points in the last few years.
What do you think about strategies for cashing out a house at retirement time? We’re a few years off, but I think when the time comes we intend to sell our primary and rental houses, and should hopefully clear 600k+. I’m a bit scared at the idea of dumping that into VTSAX all at once.
Maybe keep some portion of that in cash to find the immediate post-retirement year or two and then DCA the rest over a short period of time (a year)?