If you have the good fortune to be starting the new year with a lump sum of cash you’re looking to invest, you’re likely worried about getting into the market at the wrong time.
There are three main options as to how you invest that money: dollar-cost averaging, in which you systematically invest equal parts into a risk-appropriate portfolio over a set period; investing the lump sum in a risk-appropriate portfolio immediately; or sitting on your cash until what feels like a good time to invest.
Dollar-cost averaging may seem like a smart strategy. The logic is that when stock prices are high, you are buying fewer shares, and when prices are low, you are buying more shares. Despite its simple appeal, dollar-cost averaging has been proven suboptimal many times.
In a 2020 analysis, I compared lump-sum investing with dollar-cost averaging over a 12-month period in six stock markets and evaluated the performance over the following decade. While the cash was being deployed, it earned the rate of one-month U.S. Treasury Bills – a stable asset with low expected returns, similar to cash.
I found that investing a lump sum beat dollar-cost averaging about 65 per cent of the time across the markets in my sample. The approximate average annualized cost of dollar-cost averaging was about 0.38 percentage points over 10 years
I also looked at the performance of dollar-cost averaging in the worst 10 per cent of outcomes for lump-sum investments. I wanted to know whether dollar-cost averaging would have helped in the cases where a lump sum did not work out well.
In this subsample dollar-cost averaging has a small advantage on average, but trails lump sums in slightly more than 50 per cent of the periods. Keep in mind that this in the worst periods for lump sums. In other words, even if you knew for certain that it was a bad time to invest a lump sum – which, of course, you don’t – dollar-cost averaging is not a sure bet to improve the outcome.
In addition, I ran the analysis for the U.S. market when U.S. stock valuations were in the 95th percentile of expensiveness and found that lump sums continue to dominate.
My findings that dollar-cost averaging does not stand up to its reputation as a smart approach to deploying cash are not revolutionary. A long list of academic papers going back to the 1970s have suggested that dollar-cost averaging delivers suboptimal results.
The strongest argument in favour of dollar-cost averaging is behavioural. In short, dollar-cost averaging can help with minimizing regret by avoiding investing a lump sum right before a crash. Instead, dollar-cost averaging feels like making a series of smaller investments, spreading out the regret opportunities.
While this psychological effect is a reasonable argument for dollar-cost averaging, if an investor feels the need to dollar-cost average into a portfolio, I have to wonder whether the portfolio is too risky for the investor. It is absolutely true that investing a lump sum right before a crash can be uncomfortable, but remember that even in the worst lump-sum investment outcomes dollar-cost averaging would not necessarily have been a better option.
Some analysis suggests that dollar-cost averaging is approximately equivalent to an asset allocation where only 50 to 65 per cent of the portfolio is invested in risky assets and the rest in riskless assets – such as treasury bills – is still suboptimal compared with a lump sum investment into a portfolio with those allocations.
The alternative approach of waiting and hoping for a better time to invest, otherwise known as trying to time the market, is not much help, either. In another analysis, we looked at waiting for 10 or 20 per cent market declines to invest a lump sum and found that this strategy underperforms on average and in most of the 10-year periods in our sample.
Financial markets are constantly pricing an uncertain future. There will always be some reason – things like current market valuations being too high, geopolitical events being too volatile or economic news being too dreary – that makes the current moment feel like a terrible time to invest. But sitting on cash comes with its own risks for a long-term investor.
If you have a lump sum available to invest for the long-term, it is likely optimal to invest it as soon as possible in a portfolio that is appropriate to your risk tolerance. There is a behavioural argument for dollar-cost averaging, but if you are so worried about regretting the decision to invest a lump sum that you deem dollar-cost averaging necessary, it might be a sign to reconsider your asset allocation.
Benjamin Felix is a portfolio manager and head of research at PWL Capital. He co-hosts the Rational Reminder podcast and has a YouTube channel. He is a CFP® professional and a CFA® charterholder.