Good news – you have an extra $24,000, and you’ve decided to invest it in the stock market. It’s always nice to have investable cash on hand. But you also might feel as if the pressure is on. Nobody enjoys seeing the market take a dive shortly after they jump in. Unfortunately, we never know when it might do exactly that.
What’s an investor to do? Should you go ahead and invest the entire amount right away, or should you invest gradually, such as in 3, 6, or 12 monthly installments?
In financial jargon, this is known as lump-sum investing (all at once) vs. dollar-cost averaging (over time). In more approachable terms, it’s often described as “plunging” vs. “wading” into the deep end of the market.
Which one should you use? In terms of raw expected returns, lump-sum investing is preferred. But sometimes, there are equally valid, if less tangible reasons to favor dollar-cost averaging. In this two-part series, we’ll explore both possibilities.
Round One: Raw Returns
In a match-up against lump-sum investing vs. dollar-cost averaging, which is the better bet? Everyone from academics to financial practitioners, to the financial press has weighed in on the matter, and has reached a consistent conclusion:
Lump-sum investing generally improves your odds for earning higher returns compared to dollar-cost averaging.
- Giselle invests $24,000 as a lump sum in a low-cost, total market index fund on January 1.
- Tom uses dollar-cost averaging to invest $2,000 per month for one year in the same fund, beginning on the same date.
- They both let the results ride from January 1 through the next 15 years.
Who is more likely (although not guaranteed) to come out ahead? Giselle’s lump sum has a better chance of generating more wealth than Tom’s dollar-cost averaging.
This general expectation is well-established in academia, at least as far back as a landmark study published by George Constantinides in a 1979 Journal of Financial and Qualitative Analysis. Others have expanded on the theme ever since, examining nuances such as:
- Do the results still hold using more current data and across various markets?
- Does the advantage disappear after accounting for risk-related returns?
- Might a hybrid strategy (blending both concepts) generate even better results?
So far, our general rule of thumb holds. Even without academic analysis, this makes sense:
- When markets rise, lump-sum investing bests dollar-cost averaging: If you invest everything up front, more of your money has more time to compound in a rising market than if you’ve dripped it in more slowly. Of course, the reverse is also true. If markets go down, your bigger, earlier stake takes a bigger hit. But …
- Overall and over time, markets go up higher and more often than they go down: For example, in this short, but powerful video, Dimensional Fund Advisors shows us that U.S. stock market highs and lows have varied widely in any given year. But despite setbacks along the way, the market has prevailed and delivered a healthy 10% per year on average from 1926–2019.
- Therefore, it stands to reason: If lump-sum investing outperforms dollar-cost averaging in up markets, and markets go up more, and more often than they go down …
When the choice is available, a purely rational investor should generally prefer lump-sum investing to dollar-cost averaging.
That said, we humans love to wonder whether generalities apply to us. What if you are not yet convinced a lump-sum investment makes sense for you, your personal circumstances, and the latest market conditions?
Let’s look at when dollar-cost averaging may be preferred after all.
Considering the Big Picture
First, it’s important to emphasize:
No matter which way you go (lump sum vs. dollar-cost averaging), it’s unlikely to matter nearly as much as whether you invest efficiently to begin with.
By this, we mean:
- Planning: Start with an investment plan that reflects your personal goals and risk tolerances.
- Investing: Invest according to your plan in a balanced mix of low-cost, globally diversified index or index-like funds.
- Staying the course: Sticking to your investments over time and through various conditions.
If you can do all that, exactly how and when you add new money is less significant. The best approach for you is the one that helps you best adhere to these sensible investment practices.
Considering Your Best Interests
So, next, let’s turn away from theoretical returns and toward the main event: You.
Behavioral finance informs us, we are all subject to cognitive biases that subconsciously influence our decisions. As such, even if a strategy returns X% over Y amount of time, you’re unlikely to receive those returns if the strategy is not a good fit for your circumstances.
Let’s illustrate. Imagine investing the aforementioned $24,000 in early March 2020, just as the COVID-19 took off and markets were faltering. If you had decided to invest your lump sum right away, you would have had to soon watch it plummet amidst popular press outcries about “the fastest bear market ever,” “the worst first quarter in history,” and “the most volatile month on record.”
It just so happens, you would have come out okay had you stuck with it through the next two quarters. But nobody knew that at the time; things could have easily gotten worse instead.
Either way, would you really have been able to stay the course with a March 1 lump sum decision? Or would you have leaped back out – or never jumped in to begin with? If you had decided to wait until the market seemed more stable, you’d probably still be waiting.
If fully investing in early March would have been too daunting, dollar-cost averaging might have been better than waiting for an “all clear” signal that has yet to arrive. By setting up an automatic schedule for dripping your $24k into the market over time, you could have benefitted from some of the market recovery that has taken place, while shielding some of your wealth had the market instead continued to decline.
Even in today’s market, it could make sense – if for no other reason than psychologically speaking – to average more cash that’s been sitting on the sidelines. Most major indexes are negative YTD, discounted from prior highs.
Intentions vs. Outcomes
In short, lump-sum investing is generally expected to deliver better long-term returns if you are willing and able to stick with the strategy. But dollar-cost averaging may be the better choice if a more cautious (but still brave!) approach helps you better adhere to the larger, more important tenets of efficient investing.
So, how do you decide? That’s where TrustTree comes in as your fiduciary advisor. We can help you objectively assess the personal and financial trade-offs involved based on the best information available at the time. We can then help you stick to your well-devised plans over time and through life’s uncertainties.
By choosing the investment strategy that makes the most sense for you and your temperament, you stand the best chance of achieving your financial goals, no matter what the markets have in store for us next.