I am a proponent of dollar cost averaging (DCA) for most long-term investors.
But there are certain advantages to lump sum investing versus DCA. In fact, many studies conclude the lump sum approach is the better way to invest.
But we will consider this issue as we go through the DCA debate.
For today, I want to try and explain the shortfalls of DCA so that you get a clear picture as to the two approaches.
When we have covered both sides, you can decide what is best for you.
Assets Appreciate Over Time
Investors acquire assets that they believe will appreciate in value. So it makes sense that the earlier one purchases an asset, the greater the long-term financial gain.
This is the main advantage of lump sum investing over DCA.
For example, your research has led you to conclude that Apple is an excellent long-term investment that will steadily climb in price. If you had $10,000 on hand and ready to allocate to Apple, it may make sense to invest it all immediately.
Believing Apple will steadily grow, you are buying shares today as cheap as they will be. Whereas, if you allocate your $10,000 over a long period (1, 2, 3 years perhaps), you will be paying a higher price with each purchase date.
But Do Assets Continually Appreciate?
It should be clear to most individuals that investments fluctuate in their performance. The more volatile, or risky, an asset, the greater the probable fluctuations.
But do core asset classes appreciate over the long run?
Past performance says yes. If we look at a graph from 1925 to 2004 for cash, fixed income, and equities we see average annual positive returns.
Whether this trend continues in the future is another question. But in the past, a lump sum approach would have been profitable over long periods. A better strategy than DCA.
What About Market Short Term Fluctuations and Crashes?
Dealing with short to medium term market volatility is an advantage of DCA.
At least in theory. In actuality, a case can still be made for lump sum investing.
Perhaps you invested 100% of your funds in the U.S. stock markets in the summer of 1929. Between 1929’s peak and the 1932 bottom, the Dow Jones Industrial Average (DJIA) fell 89%.
Yet over the long run, you still would have turned a profit with lump sump investing. Even if you had bought at the high point in 1929.
Of course, it would have taken until 1954 to get back to your initial break-even point. But once there, it was smooth sailing for long-term growth for a while. Assuming that you were still alive 30 years after the crash, you would have seen positive growth.
Or what if you invested 100% of your assets in early October, 1987? On October 19, the DJIA fell 22% in a single day. It took until late 1989 to fully recover.
Or in early October 2008? On October 1, the DJIA traded as high as 11,022. By October 10, it had reached a low of 7774 before closing the day at 8451. A 29.5% drop from high to low in just 10 days. Had you bought just prior to the crash, with a brief exception in April 2010, you would have only returned to your initial investment level at the end of 2010.
So while the lump sum approach may prove superior, you might be in for a lengthy wait to achieve the returns.
DCA May Provide Protection for Shorter Term Time Frames
While the markets for core assets have provided net positive returns over time, there clearly have been hiccups along the way.
This chart from 1900 to present provides a nice picture the DJIA general growth and fluctuations over time.
To smooth short and medium term volatility, DCA provides some protection.
So DCA is the Best Approach?
For shorter time frames, DCA may allow for outperformance.
But even with short and medium term fluctuations, based strictly on long-term results, lump sum investing usually outperforms DCA.
This is due to two reasons that must be taken together.
One, as we have seen above, over the long run the price trend is up. If you hold forever, then buying sooner is normally better than slowly amassing the same asset over time.
Two, in the grand scheme of the investing time frame, the probability that you will make your lump sum purchase the day (or week or month) before a crash or severe correction is small. If you look at the chart I linked to on the DJIA from 1900 onward, there are relatively few large downward corrections.
So for the most part, you will not likely suffer extensive timing issues like the ones that occurred in October 1987.
That is why studies conclude that even with the ups and downs that arise in the markets, a lump sum strategy will normally outperform DCA.
For example, way back in 1979, George Constantinides published, “A Note On The Suboptimality Of Dollar Cost Averaging as an Investment Policy.” Constantinides concluded that DCA is an inferior strategy to lump sum investing.
In 1992, Knight and Mandel authored “Nobody Gains from Dollar Cost Averaging Analytical, Numerical and Empirical Results” which stated that “optimal rebalancing and ‘buy and hold’ achieve better performance”.
And in 1993, Williams and Bacon concluded in “Lump Sum Beats Dollar Cost Averaging” (no link) that ”… the odds strongly favor investing the lump sum immediately [as opposed to spreading it out over equal installments].”
The common theme in all these studies is that the longer the investment time frame, the greater the probability that a lump sum investment will outperform DCA.
Not 100%, but approximately 60-66% of the time based in backtesting studies done.
Less Fees in Lump Sum Investing
A second advantage of lump sum investing relates to transaction costs.
A lump sum investing approach should result in less transaction costs than under DCA.
Many online brokers now offer flat fee trades, regardless of shares bought or sold.
If you invest $10,000 in one lump sum, you may only pay a $10 commission. But if you divide that $10,000 into 10 separate transactions, you will end up paying $100 in total.
While not a lot, it is 1.0% of your initial capital. And given asset returns over the last decade, it should not be ignored.
That said, this is less of a problem now than it was 10 or more years ago. Back then, commissions were much higher and buying small lots of shares may have cost upwards of $50 or $100 per transaction. If you are investing $1000 each time and paying a 5% or 10% transaction fee, then that does cause significant problems over time.
Okay, that is the case for lump sum investing.
It is cheaper and studies conclude the lump sum approach outperforms DCA over the long run.
I like low cost. And I love outperformance.
So why do I think DCA is appropriate for most investors?
We will get to that in Advantages of Dollar Cost Averaging.
