You’ve just come into some money. Whether it’s a bonus, a tax refund, inheritance, or from the sale of a business, a big question is how do you invest the money. Is it better to invest it all at once, or should you spread the investments out over time? In this article we’ll compare lump sum investing versus dollar cost averaging.
- Dollar Cost Averaging vs. Lump Sum Investing
- 9 Things to Consider When Investing a Windfall
- Final Thoughts
Three years ago I sold part of my business. The result was a lump sum that I planned to invest. The big question then was whether to invest it all at once or to slowly invest it over time. I chose lump sum investing, and it worked out well. Yet lump sum investing is not always the best choice. We’ll first look at the difference between these two approaches. Then we’ll walk through nine factors to consider as you make the best choice for you.
Dollar Cost Averaging vs. Lump Sum Investing
Let’s first make sure we understand the terminology. Lump sum investing is easy. You take your windfall and invest it all at once. If you follow an asset allocation plan of 70% stocks and 30% bonds, for example, you would immediately invest the money accordingly.
Dollar cost averaging, by contrast, spreads investments out over time. For example, you may invest 1/12th of your money each month for 12 months. With dollar cost averaging (DCA) , you need to decide over what period of time you’ll put your money to work. In one Vanguard study, which we’ll look at in a minute, they considered DCA investments spread out over 6 months all the way up to 3 years.
There is no one “right” answer to how long you should spread out your investments if you follow the DCA approach. The longer the time period, the longer your money sits in a cash account waiting to be invested. The shorter the time period, the faster you expose your money to the risks and rewards of the market.
9 Things to Consider When Investing a Windfall
1. We Can’t Predict the Future
It’s important to accept that we cannot know in advance whether investing all of the money at once will end up being the best result. There's just no way to know in advance which approach will put more money in our pockets. In the words of Yogi Berra,
It's tough to make predictions, especially about the future.
It's important when it comes to investing that we understand the limitations of our knowledge. Don’t be fooled by investment news that’s filled with market predictions. As Warren Buffett says, a stock market prediction tells us more about the prognosticator than it does the future.
2. Even Accurate Market Predictions Don’t Help
Even if we knew where the market would stand a year from now, we still wouldn't know whether lump sum investing or dollar cost averaging would lead to the best result. Now that may seem counterintuitive. The reason is simple.
Let’s assume that we knew the market would be up 10% a year from now. What we don’t know is how it got there. We can image three scenarios:
- The market gradually rises throughout the year, arriving at a 10% gain.
- The market soars well above 10%, but then falls back down at the end of the year, arriving at a 10% gain.
- The market tanks well into loss territory, much like it did in 2020, then rises later in the year, arriving at a 10% gain.
For scenario #1, lump sum investing would be best to benefit from the nice steady gains for the year.
For scenario #2, lump sum investing would also work out best. Why? Because we would be buying at the low point for the year. Dollar cost averaging would have us buying at elevanted prices during the year.
Scenario #3, however, would favor dollar cost averaging. Because the market sank during the year, DCA would allow us to invest in the market at lower and lower prices.
So even if we knew the outcome of the market for the year, that still wouldn't tell us which approach would work out better.
3. Market Valuations can be Misleading
The above example assumed we knew the market would go up by 10% over the next year. Some believe the market is overvalued and may go down over the next year. Even if we assume they are right and that the market will be down by 10% or more, we still cannot know whether lump sum or dollar cost averaging would lead to the best outcome. Why? For the same reasons we just discussed. We don’t know how it's going to get from where it is today to where it might be a year from now.
4. History Favors Lump Sum Investing
While there’s a lot we don’t know, we do have several factors that can help us make a reasonable decision. Vanguard published a study in 2012 that compared lump sum investing with dollar cost averaging. Here's how the study worked:
- Vanguard looked at three different markets–the United States, United Kingdom and Australia.
- It then examined rolling 10 year periods from 1926 to 2011. The rolling periods incremented by month, so Vanguard examined over 1,000 10-year rolling periods.
- It considered different stock/bond allocation.
- For dollar cost averaging, Vanguard looked at periods ranging as short as six months to as long as 36 months.
Vanguard found that at the end of the 10-year period, lump sum investing beat dollar cost averaging about two thirds of the time. The results were consistent across the U.S., the United Kingdom, and Australia.
If you're a numbers person and want to take the approach that gives you the best chance of having more money, then according to this study, lump sum investing would be your best approach.
5. Avoiding Losses Favors Dollar Cost Averaging
Some of you may be more concerned about losing money than you are maximizing your returns. Vanguard’s study provides insight into this perspective as well. What it found was that during a down market, dollar cost averaging resulted in losses less frequently than lump sum investing. Specifically, the study found that lump sum investing declined in value 22.4% of the time. Dollar cost averaging was down 17.6% of the time.
So if your concern is preservation of assets, dollar cost averaging might be the better approach.
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6. The Difference is Modest
While lump sum investing wins out most of the time, the difference is relatively small. Assuming a 60/40 portfolio in the United States, lump sum investing beat out dollar cost averaging after a 10 year period by 2.3%. So I don't think we're talking about huge sums of money. While I'm a big believer that every basis point counts, for most of us it's probably not a life changing decision.
7. Consider Your Risk Tolerance
Our emotions can get us into trouble when it comes to investing. That’s true when we get scared, and it’s true when we get excited. Both can lead us down the wrong path. Vanguard highlighted this fact in its study:
But if the investor is primarily concerned with minimizing downside risk and potential feelings of regret (resulting from lump-sum investing immediately before a market downturn), then DCA may be of use. Of course, any emotionally based concerns should be weighed carefully against both (1) the lower expected long-run returns of cash compared with stocks and bonds, and (2) the fact that delaying investment is itself a form of market-timing, something few investors succeed at.
If an investor goes all in with a lump sum investment and then the market craters, it could have a negative effect on them for years to come. To protect against this outcome, dollar cost averaging may be the better approach. It’s also consistent with the concept of loss aversion. As Daniel Kahneman, author of Thinking, Fast and Slow, found back in 1979, “losses loom larger than gains.”
However you choose to invest a windfall, it's important to think about the emotional side of investing, not just the numbers.
8. Focus on Your Goals
It's always important to consider your ultimate goals. If you can reach your goals taking a more conservative approach, why would you assume more risk? This is particularly true for those nearing retirement.
When you're 20 and come into some money, you have a long runway to deal with any mistakes that you might make or bad markets. When you're my age your runway is a little shorter. You don’t have as much time to recover from some big mistakes. So it's always important when you're making any financial decisions to always keep the end goal in mind. Once you've won the game, stop playing. I think it's worth keeping that in mind as you make this decision for yourself.
9. Follow a Plan
You should always have an investment plan. If you want to dollar cost average, come up with a plan, put it in writing and stick to it.
For example, you may decide to dollar cost average over 12 months. You're going to take one-12th of your money and invest it in each of the next 12 months. Put the plan in writing and then do it no matter what.
Let's think back to last year–2020. Let's imagine in January you planned to dollar cost average over the next year. In January and the first half of February, everything seems to be going just fine.Then in March the floor drops out from under us. Would you have stuck to your plan? Would you have continued to invest 1/12th of your windfall each month?
It's critical that whatever you decide to do, plan it out, put it in writing and stick to it. That avoids the market timing that Vanguard warned about. In fact, if we look back to last year, had you gotten scared and abandoned your plan, you would have come to regret it. Of course, 2020 could have worked out differently. The market could have continued to fall.
And that’s the point. We don’t know how the market will perform in the future. That's why it’s so important to come up with a plan, put it in writing, and stick to it. We should do that with our asset allocation plan and our approach to rebalancing.
There isn’t one right answer in the lump sum investing versus dollar cost averaging debate. The above, however, represents the key factors to consider. Whatever you decide, put your plan in writing and follow it.