When investing, two common methods for deploying capital into the markets are dollar-cost averaging and lump-sum investing. What does this mean?
Let’s say you have US$1,000,000 available to invest; lump-sum means investing that whole amount into the market all at once. All US1,000,000 is susceptible to the market ups and downs right from the first day you invest.
Dollar-cost averaging means you are drip-feeding your money, often in equal amounts into the market over time, such as a monthly basis. When markets are down, you are buying more units for your money as the price is lower, which means when markets rise, you own more units that increase in value. Conversely, now that markets are higher you are buying fewer units for the same amount of money.
The idea is that your returns will be less volatile and will sit somewhere between the highs and lows of the market.
There is much discussion over which method provides the best outcome for investors. While the data may suggest a clear winner, the decision of which approach is right for you may come down to more than just investment returns.
What does the data say?
The fear associated with lump-sum investing is that if you invest all at once and the market suddenly dips, you experience a bigger loss compared to that of dollar-cost averaging. While this is a risk, the same is true for when markets are positive, all of the invested money will experience all of the gains.
When investing bit by bit into the market, you would be somewhat protected from sudden market declines, but you would also not experience the full benefit of positive returns. Uninvested funds may likely be sitting in cash, with its purchasing power eroding from inflation if held for a long time.
As a very simplified example, consider a US$1,000,000 investment in a year where returns are positive each month. Here a dollar-cost averaging approach would be less favourable as each instalment results in you buying less invested assets for your money. Whereas if you invested US$1,000,000 at the beginning of the year, you have purchased more invested assets at a lower starting price that have increased in value each month.
In reality, no one has a crystal ball to know if this will happen, and markets do not behave in this way. Some years lump sum investing will give you a better outcome, some years not and nobody can tell which will be which. However, most people accept the idea that over the long term markets generate positive returns more often than not.
Research finds consistently that over the long term, lump-sum investing generates better financial outcomes than dollar-cost averaging roughly two-thirds of the time.
The data also allays fears of lump-sum investing being more vulnerable to market timing errors.
|S&P500 1926-2019||1 Year||3 Year||5 Year|
|S&P 500 After New Market Highs||13.9%||10.5%||9.9%|
|S&P 500 After Decline of More than 10%||11.3%||2.0%||2.0%|
Source: Dimensional Fund Advisors
The table shows that from 1926-2019 when the S&P500 index hit new all time highs, for the following 1,3 and 5 years, returns were still positive. When the index had declined by more than 10%, the following 1,3 and 5 years were also positive. The main takeaway here is that remaining invested in the market counts.
Based on solely financial results, lump-sum investing comes out on top.
Lump-sum investing may give you better results if you have the discipline to stay in the market, but in reality, this is easier said than done. When markets are up and down, emotions can get the better of people, and they may withdraw just at the wrong time. Or people may procrastinate over the fear of timing their investment ‘incorrectly’ resulting in not investing at all. There could be sentimental value attached to your funds maybe from receiving an inheritance which, may make investing all at once emotionally difficult. In these situations, investing small amounts consistently may be a better option emotionally.
Depending on your situation, it may be more practical to choose one method over the other. For people in their early careers or just starting in their investment journey, it may not be realistic to invest large lump sums. Investing smaller amounts from their salary each month may be far more achievable.
On the other hand, for those that find it challenging to sit on funds in cash and not spend for an extended period, it may make sense to put all of their money to use right away.
A significant benefit of dollar-cost averaging is that there is more structure and systemisation. You invest the same amount at the same time interval so are taking some the emotion and fear out of the equation. Lump-sum investing will likely give you an edge financially if you can stick to it.
I would argue that as an investor, it is not a question of which approach is best, but more which you are you able to stick to over the long term. Both methods take advantage of the benefits of long-term investing, consistency and sticking to a plan is what will determine your success.
Pyrmont’s approach to investment management is to help you understand what type of strategy would be suitable for you based on your past experiences and to guide you on an ongoing basis towards sticking to something sensible long term. Get in touch today to get started.