Lump Sum Investing vs. Dollar Cost Averaging

Lump Sum Investing vs. Dollar Cost Averaging

I ran across an interesting discussion on the Bogleheads Investment Forum. It centered on the issue of lump sum investing vs. dollar cost averaging.

With lump sum investing, you take whatever you have on hand to invest and you put it in the market all at once in your desired asset allocation. With DCA, you invest it in chunks over a period of time. As the market rises, you get fewer shares. As it falls, you get more.

In general terms, DCA is a risk avoidance strategy. Viewed in a vacuum, this might be good. On average, however, it also reduces your expected returns. The reason for this is that, historically, the market has trended upward.

By holding money in cash, you’re missing out on a portion of this expected return. Of course, the market is anything but a smooth ride, so by holding a portion of you money on the sidelines you avoid the risk of buying in before a major downturn.

Okay, let’s just stop and think for a moment… Let’s say you have a target allocation of 60% stocks and 40% bonds on you inherit a million dollars in cash.

Assuming that your target allocation remains the same and that you ultimately want all of it invested, would you immediately buy $600k in stocks and $400k in bonds? Or would you sit on the cash and deploy it a little at a time — say $50k per month for the next 20 months?

I’d bet that a fair number of you would opt for the latter. Put the money in the market a little at a time to avoid a calamity. But is that really the wise thing to do?

A commenter named Don offered up this hypothetical scenario:

Let’s say you inherit a large portfolio, and by the grace of the gods, on the day you inherit it, it happens to match your preferred asset allocation perfectly.

Would you:

1) immediately liquidate to cash and start dollar cost averaging back to your asset allocation.
2) sleep well knowing that you have a well diversified portfolio appropriate to your risk tolerance and goals.

I would wager that almost everyone would choose 2.

I would tend to agree with Don’s assessment — that most people would choose option #2 and leave well enough alone.

But why?

Ignoring possible tax implications (which is fair because of the stepped-up basis associated with an inheritance), option #1 is the equivalent of receiving a cash windfall and dollar cost averaging — which I suspect many people would do. In contrast, option #2 is the equivalent to receiving a cash windfall and immediately dumping it in the market.

Perhaps I’m wrong about what “most people” would do, but I have to admit that I’d be inclined to DCA a large cash windfall, whereas I’d leave well enough alone if I inherited a portfolio that matched my desired allocation. Does this make sense? Not really, but that’s what my gut would tell me to do. Which leads back to the above question… Why?

I guess it’s because a loss following a conscious decision to make a lump sum investment would sting more than an equivalent loss that resulted from inaction (i.e., allowing an inherited portfolio to take a nosedive). Yes, I realize that I’m ultimately making the decision in both cases, but in one case I’m taking action, and in the other case I’m not.

Irrational? Absolutely. Which is why it’s important to take a step back and analyze situations like this. As a wise man once said, money is more about the mind than the math.

As an aside, if you are deathly afraid of the loss that you might incur when making a lump sum investment, you might want to reconsider your risk tolerance. Perhaps this is a sign that your investments are too aggressive and that you should shift toward a more conservative allocation.

24 Responses to “Lump Sum Investing vs. Dollar Cost Averaging”

  1. Anonymous

    I am currently planning a lump sum investment of an inheritance and that is why I am reading here. I’m leaning towards an initial 40% investment into a diversified but conservative portfolio followed by between 6 and 12 monthly installments unless the market drops…then I’m going all in. Kind of hedging my bets between DCA and lump sum with the ability to buy in cheap if the opportunity arises in my timeline. I think it may have the best of all worlds by adjusting the monthly installments to whether the market is gaining or losing.

  2. Anonymous

    Hey Nickel

    I love reading your blog post, they’re a refreshingly honest look at a lot of areas of money and finance for a lot of people like myself trying to learn more about ways to make smarter decisions about my money. I don’t pretend like I understand everything, but I’m working hard to learn, and I really like how you go through relevant stock news stories and really hash out their consequences.

    As a complete beginner though, it’s been hard for me to find really good, straightforward lessons to begin investing. I read some great articles at Investopedia.com, but other than that, it’s been hard to find good advice for beginners. The one really eye opening article I read was one about the after inflation returns for savings compared to investing at Wealthlift.com.

    Knowing all that though, what sites would you personally recommend for beginning investors? Both Investopedia.com and Wealthlift.com were great starts, but I’d still like to learn more and more. I have a lot of friends asking me the same thing now that I’ve begun learning, and I plan on sending your suggestions to my friends and family as well.

    Thank you in advance,
    Georgia

  3. Anonymous

    I believe in educated dollar cost averaging. Don’t just buy at regular intervals, buy when you think the market is in a relative dip, like after the market tanks for a few days in a row. You can take advantage of market variation even if the market tends to go up in the long term. Sell in a similar manner. If you make 2% 10 times, you earn 21.9%!

  4. Anonymous

    I would DCA the money in, but over a shorter time frame (like a few months). If the markets were not so volatile (4% daily swings) then I would lump sum it in.

    Is this trying to time the market: YES. But you are also timing the market when you do a (automatic) rebalance.

  5. Anonymous

    This was covered years ago at My Money Blog: http://www.mymoneyblog.com/dollar-cost-averaging-a-poor-way-to-reduce-risk.html. The bottom line is “Due to the overall upward trend of the markets, lump-sum investing outperforms DCA about 2/3rd of the time.” This is based on actual research and academic papers. The article also points out that, as far as risk-avoidance strategies go, there are superior ones to DCA.

    It is also worthwhile to point out how often DCA is misused, even by financial professionals. If you are buying into the market a little at a time (such as regular contributions to your 401K) because that is all you can afford, that is NOT DCA. That is just buying as much as you can, as soon as you can. DCA really only applies when you have a lump sum to invest, but consciously choose to invest it slowly as a risk-avoidance strategy.

  6. Anonymous

    Hi Nickel–I said it was a contrarian postion! I know what you mean about the risk to cash. But I’d still be getting some interest on the money, and could also take a small position in a gold ETF if I though things would get much worse.

    The bigger risk, IMHO, is taking a 30, 40 or 50 percent hit by being heavily in the market when prices are rich. It would take a lot of years of gains to offset that.

    And even though interest rates are low right now, a sudden rise could be the catalyst that causes the next crash. You may have inflation risk with cash, but you have interest rate risk with stocks, and right now that’s substantial. Rates have no where to go but up from here.

    BTW, if I knew the answer to that last question, I wouldn’t be commenting on blog posts! (!!!)

  7. Kevin: The longer you sit on the sidelines in cash, the more inflation risk you have. It’s important to keep in mind that cash is not riskless. It’s just a different type of risk.

    P.S. Please let me know when it’s time to buy/sell. 😉

  8. Anonymous

    I’m going to take the contrarian position and say “none of the above”. Foundationally, I don’t believe the stock market is an all-weather investment, there are times to be in and times to be out.

    If I inherited a million dollars, I’d sit on the cash and wait for the market to have another crash. If the inheritance matched my allocation preferences, I’d sell the stock positions and go to cash and wait for the market to have another crash.

    Stocks to me are like anything else–buy at a discount or don’t buy. Now I might use DCA post crash to move into the market gradually, just in case the market has further to fall.

    We’ve had 3 crashes in less than 25 years, including two in the last ten years. I think that’s something we need to plan for! And if I have $1 million I have something to lose that I’d be especially careful about.

    If the market crashes, I’ll be taking on far less risk and the potential for far greater gains. If it never crashes and I never buy in…I’d still be a millionaire.

    Yep, that’s what I would do.

  9. Anonymous

    How many people are fortunate enough to be able to invest a lump sum? I’m forced into DCA because I am only able to invest when my pay checks come in.

    If I received a large cash inheritance, then I wouldn’t dump everything in the market all at once. But if I received stocks and bonds, I wouldn’t touch it. This is just like your article. But I’m not thinking DCA vs. lump sum.

    One thing to keep in mind. If you dump $16,500 into a 401(k) at the beginning of the year, you’re NOT lump sum investing. Why? Because next year, you’ll dump another $16,500 (or whatever the limit is). The year after, you’ll put in another $16,500. Another year, another $16,500. That’s technically DCA.

  10. Anonymous

    Why the paradox? The status quo bias certainly plays a role. When you have cash, the cash is the status quo. When you have shares, the shares are the status quo.

    However, although the hypothetical is interesting, it will never happen, versus the more likely inheriting cash scenario. There’s no way that I will just so happens inherit shares exactly the way I like them. If I do inherit shares, it’s probably going to be a mixed bag of things. I will sell them for cash and then DCA into what I want.

    In addition, if the inheritance is much larger than what I already have, my need and willingness to take risk will change. I won’t know what I want. That’s another reason I will sell them for cash and take my time to DCA. That allows changing of mind and adjustments along the way.

  11. Anonymous

    Loss avoidance and decreasing risk is a profound motivator for people to employ DCA. According to historical data, lump sum will beat DCA 66% of the time. The problem is that no one wants to be in that other third. I would DCA myself.

  12. Anonymous

    I didn’t read all the comments but O’Neil (publisher of Investors Business Daily) said investing a lump sum in a mutal fund could be profitable if the market experiences a huge, out-of-the-ordinary drop (for example, post September 11, 2001).

    It thought of his advice a week or two ago when Congress finally passed their budget and the market took such a hit.

  13. Anonymous

    So far, this discussion is purely academic since few of us are likely ever to come into a substantial lump sum.

    The reality is that most of us DCA into the market because we don’t have the money up front.

    The whole DCA rationalization came about so that people didn’t feel so bad about getting worse performance by investing over time when they don’t have the means to invest all of the money they’ll ever invest NOW, rather than slowly over 30 years. As Nickel points out the former has been shown statistically to be the better option.

  14. Anonymous

    Why not put 60% in stocks and 40% in bonds right away and invest all the interest from the bonds into the stocks? Most mutual funds distribute them the same as dividends. With this technique, you’d get the benefit of dollar cost averaging while still having your portfolio in your desired allocation.

  15. Anonymous

    Edit for above post: Take DCA approach and you make nearly 0% for the amount sitting by idle in a money market/savings. Obviously the parts you start to invest make some, depending on the market, frequency/amount of investments.

  16. Anonymous

    While a million IS a lot, it wouldn’t be all that relevant; the same fundamentals still apply. Think 8% annual return–to sooner you get that million in, the sooner you gain $80,000 per year for doing NOTHING. Take the Dollar Cost Averaging approach and you make nearly 0% with interest rates being where they are.

    If you get that money into the market and have some really bullish initial years, you’d be really happy you invested it when you did, as opposed to buying fewer and fewer shares every period of DCA. The return could amount to a LOT of money, and dividends could amount into hundreds, if not thousands of dollars. Of course, if its a bearish market, you’d be mad at yourself. As I mentioned before, no one can predict the future, so I’d be likely to take the half and half approach.

    Also consider that if you have your money sitting in an money market or savings waiting to be spent via DCA, you might be have “emergencies” arise where you want to spend it. In my eyes, if the money is committed to the market (in the form of mutual funds), I don’t take it out unless it’s a REAL emergency. Stocks on the other hand, I’m willing to play with. Just my 2 cents.

  17. Anonymous

    I think it will depend on how much money the portfolio is worth. In this case, I believe it is a million dollar inherent. To me, with this amount of money, it would be a wiser decision to play DCA to manage where the money is being invested. Lump sums should be much smaller investments to gain more and more interest over time.

  18. Anonymous

    Here’s what I would probably do in this situation:

    I would take half of my money and invest it immediately, maintaining my desired allocation.

    I would take the other half, put it in my money market (or savings), and invest it over time.

    Because nobody can predict the future, I choose a half-best-case scenario.

    Referring to the metaphor where we choose to go to Grandma’s, it’s like sending half the family in one car on the highway, the other on side streets (in real life, it is a waste of gas and I would never do this).

    Either way, Grandma wins (because we eventually get there with wise money management), and whichever part of the family gets there first wins. Or, maybe they’ll get there at the same time? If there is an accident on the freeway, perhaps that half could manage to get off at an exit and take sidestreets the rest of the way (reallocation as time goes on). Or maybe the sidestreet car just has the best luck with traffic and hits almost no red lights (the benefit to DCA and being lucky with down days when it’s time to dump more in).

    Either way, I am not upset with myself for choosing the “wrong option” while reviewing the past.

    I actually follow this methodology in my 401k (the TSP). I allocate half into the lifecycle fund, thereby allowing the Thrift Savings Plan “manage” half of my allocation, and the other half I set (to a particularly risky allocation). That way I’m not mad at myself for “screwing up” one way or the other. Granted I may not get the absolute best return, but again, no one can predict the future. And if you can, give me a call, we have business to do.

  19. Jim: That is an interesting and through provoking analogy, but it only goes so far, and doesn’t fully reflect the sorts of risk (or the underlying math) that we’re talking about.

    How would you respond to the two scenarios outlined above? If handed the cash, would you DCA or lump sum? And if given a portfolio that was already in your desired allocation, would you sell and DCA back in? Or would you sit tight?

    The main point that I’m making above is that lots of people would give divergent answers when faced with these two scenarios. From a mathematical standpoint, DCAing from cash into the portfolio and selling out to DCA back in are identical. Yet most people wouldn’t treat them as such.

    If you are only concerned with reaching your target allocation, then the correct answers to the above scenarios would be to lump sum in or to sit tight with the already-allocated portfolio.

    If you are concerned about minimizing risk in the face of a potential market collapse in the coming months, then the correct answers would be to DCA from cash into the market, or to sell out and then DCA back in.

    Again, from a mathematical standpoint, those two pairs of responses are essentially identical. And yet — if I’m right — a lot of people would give divergent answers.

    For example, my gut reaction would be to DCA in from cash to avoid the regret associated with buying in just before a market collapse, but to sit tight if handed an already-allocated portfolio despite the fact that I’d be facing the *exact* risks that my DCA answer was meant to avoid.

    In other words, my gut reaction is irrational. What about yours?

  20. Anonymous

    Teh same type of thought should be applied when you find yourself in a negative situation. Take for example a person in an underwater mortgage who is having money troubles. Most people would avoid selling the house due to the losses already incurred in hopes that if they stay alive financially the home’s value will rebound. In fact the original situation has nothing to do with the decision.

    What you should do is determine what your situation would be if you acted, then decide if you would reverse it to be in your current situation. For example: You bought your home for $200,000 5 years ago and your mortgage balance is now $150,000. The home would sell for $130,000 net today, leaving you with a $20,000 shortfall. You place yourself in the resulting situation: You have $20,000 in debt and you can buy a home for $130,000, leaving you with $150,000 in debt. In either situation doing nothing appears to be the right thing, but it’s easier to determine which action is the greater wrong.

  21. Anonymous

    Having a balanced portolio is the goal of DCA. If you start with a balanced portfolio then you are already at the goal so you don’t need to use DCA. At the end of the whole thing you want to be invested in stocks/bonds in a certain mix.

    DCA isn’t the goal, its just a process to get to the point you want to be.

    Let me make anohter analogy :

    Lets say you want to drive to your grandma’s house. You could take the quick route but that path is along the freeway which can be clogged with traffic if theres an accident or if you hit people leaving a concert.
    OR
    You could drive the surface roads. The surface roads are much less risky but a slower.

    Many people will chose the surface roads so they have a better chance of getting to grandma’s on time safely.

    OK, now lets pretend you’re already at grandma’s house. Would you drive your car backwards down the freeway or would you drive your car backwards on the surface roads?

    See my point?

    DCA is the route you take to get to the goal. If you’re at the goal already then routes to get there are irrelevant.

  22. Andrew: While it’s certainly possible to create scenarios in which DCA wins, given that markets rise (on average), the expectation is that lump sum will beat DCA. DCA “protects” you from extreme results, which could be good or bad. Given a distribution of possible returns over time, DCA will cause you to avoid both the best and worst case scenarios.

  23. Anonymous

    Incredibly thought-provoking post. I think you’re over-simplifying dollar-cost-averaging, though. The reason it works is because you earn more money on a stock that was bought at $5 and grows to $10, compared to how much you lose on a stock that goes from $15 to $10. In the first example, you double your money, but in the second, you only lose 33%.

    If I were a conservative investor buying fixed income, I would not DCA. There just isn’t enough volatility. But, if I’m an aggressive investor with a long timeframe, there’s a much greater chance of coming out ahead when you DCA.

  24. Anonymous

    Imagine that you are standing next to a railroad switch. On one fork of the tracks is tied a baby. On the other set there is a bucket full of 10 babies. There is a train coming. What should you do if
    a) The switch is currently set to the track with one baby?
    b) The switch is currently set to the track with ten babies?
    I have read that the action is the same in both cases: Nothing. (Though I’m not sure I understand why nor agree.)

    So, there is an argument that there is a different culpability between choosing to invest and losing money, and choosing not to de-invest and losing money.

    Still, personally I would put the money where I intend it to go long term. If nothing else, because that means 19 less times I have to figure out where precisely to put it.

Leave a Reply