Monday, May 12, 2014

Dollar Cost Averaging Versus Lump Sum Investing

Dollar cost averaging is a process, where the same amount of funds is allocated to preset investment/s at regular intervals of time. It is widely believed that investors who choose to systemically allocate funds towards their investments are reducing their risk of investing their whole amount at the top of the price range.

Most individuals use dollar cost averaging to purchase investments. The reason behind these actions is the fact that most individuals are able to allocate funds for investing once a month or every two weeks for example, depending on the frequency with which they are able to save money. If our investor is able to save 15% of their illustrative $1000 monthly salary, which is paid every two weeks or twice/month, they would be able to allocate anywhere between $150 - $225 every month towards their retirement investments. The $225/month is derived for the situation where a person who is paid bi-weekly ends up receiving three paychecks instead of three. Either way, the typical 401 (k) investor would purchase the same funds whenever they get paid. The typical dividend investor would likely accumulate new contributions with any distributions from their portfolios, before they make their stock investments. Depending on portfolio sizes, minimum amount of purchases and amount of distributions per month, dividend investors end up purchasing different dividend stocks on a regular basis, which closely mimics the practice of dollar cost averaging.

Unfortunately, few investors have large amounts of cash simply sitting around, that they need to dollar cost average. For those lucky enough to have this happen to them, dollar cost averaging can be a tool to minimize risk of purchasing at the top. It would also help them in gaining more experience in the markets, particularly if they had none whatsoever previously. For lottery winners or those lucky individuals who happen to obtain a lump sum of cash, dollar cost averaging might be a great way to handle the bounty.

In order to test whether dollar cost averaging gives investors an advantage over lump sum investing, I obtained monthly data for the Vanguard S&P 500 mutual fund (VFINX) between 1987 and 2012. In order to calculate dollar cost averaging results for a given year, I would put $100 in investment every month beginning in the last day of the last month of the previous year, up until the last day of November for the next year. For lump-sum amounts, I would put a theoretical $1200 investment either at the closing prices for the previous year. I would then multiply the number of shares accumulated for both dollar cost averaging and lump sum investing times the ending prices by the end of the current year. Next, I would then compare which strategy delivered better results for the given year.


Year
Lump Sum
DCA
Result
1981
 $     1,096.25
 $     1,132.79
DCA Outperforms
1982
 $     1,430.91
 $     1,445.19
DCA Outperforms
1983
 $     1,404.76
 $     1,230.79
Lump - Sum Outperforms
1984
 $     1,244.75
 $     1,255.54
DCA Outperforms
1985
 $     1,470.59
 $     1,307.08
Lump - Sum Outperforms
1986
 $     1,312.00
 $     1,161.11
Lump - Sum Outperforms
1987
 $     1,272.20
 $     1,079.40
Lump - Sum Outperforms
1988
 $     1,396.01
 $     1,281.65
Lump - Sum Outperforms
1989
 $     1,576.53
 $     1,358.14
Lump - Sum Outperforms
1990
 $     1,159.66
 $     1,210.21
DCA Outperforms
1991
 $     1,562.62
 $     1,364.10
Lump - Sum Outperforms
1992
 $     1,298.09
 $     1,287.25
Lump - Sum Outperforms
1993
 $     1,309.69
 $     1,259.67
Lump - Sum Outperforms
1994
 $     1,214.18
 $     1,214.05
Lump - Sum Outperforms
1995
 $     1,649.00
 $     1,414.38
Lump - Sum Outperforms
1996
 $     1,474.57
 $     1,357.91
Lump - Sum Outperforms
1997
 $     1,598.02
 $     1,382.72
Lump - Sum Outperforms
1998
 $     1,543.42
 $     1,401.32
Lump - Sum Outperforms
1999
 $     1,453.02
 $     1,357.42
Lump - Sum Outperforms
2000
 $     1,091.35
 $     1,115.29
DCA Outperforms
2001
 $     1,055.63
 $     1,162.53
DCA Outperforms
2002
 $       933.95
 $     1,066.36
DCA Outperforms
2003
 $     1,542.02
 $     1,428.79
Lump - Sum Outperforms
2004
 $     1,328.79
 $     1,304.03
Lump - Sum Outperforms
2005
 $     1,257.31
 $     1,255.83
Lump - Sum Outperforms
2006
 $     1,387.64
 $     1,319.41
Lump - Sum Outperforms
2007
 $     1,264.78
 $     1,208.97
Lump - Sum Outperforms
2008
 $       755.72
 $       888.44
DCA Outperforms
2009
 $     1,518.14
 $     1,476.44
Lump - Sum Outperforms
2010
 $     1,379.02
 $     1,365.85
Lump - Sum Outperforms
2011
 $     1,223.41
 $     1,194.23
Lump - Sum Outperforms
2012
 $     1,389.95
 $     1,264.06
Lump - Sum Outperforms
2013
 $     1,586.04
 $     1,392.64
Lump - Sum Outperforms
Overall, lump-sum investing performed better in 25 out of 33 years. Dollar cost averaging performed better in only 8 out of 33 years. Not surprisingly, these were the years when the stock market was either flat or declined. As a result, dollar cost averaging reduces investor’s risk when things were difficult, but at the expense of foregone gains when things went well. Because stocks have a historical tendency to move up over time, investors who practice dollar cost averaging might be at a disadvantage. Of course, for those who practice dollar cost averaging because they didn’t have the lump-sum in the first place, this is still the best way to accumulate a sizeable nest egg.

In this exercise we did not look at other key components of investment which deals with investment selection, analysis, valuation and purchase. We assumed that these decisions have already been made. In reality however, there could be a situation where our investor might not find any potential assets that have sufficient low valuation to merit investment in them. Most index investors or savers in a 401 (k) invest regardless of overall valuations.

Full Disclosure: Long S&P 500 Index Fund in my 401 (k)

Relevant Articles:

How to accumulate your nest egg
How to retire in 10 years with dividend stocks
Optimal Cash Allocation for Dividend Investors
How to Generate an 11% Yield on Cost in 6 Years
How to be a successful dividend investor

11 comments:

  1. I don't personally like dollar cost averaging. Its probably good for some ETF structure of passive investing, but certainly not for a dividend investor. As way of example, I may find a particular company properly valued at the moment and decide to place a position on it, but such may not be the case next month. I don't wish to purchased companies that are over valued just because I'm following a strategy.

    ReplyDelete
  2. A great subject for a post, as it is the source of plenty discussion. And as expected (given majority of investors expect the market to go up in the long run) lump sum is the choice with the highest expected return. However a lot of investors, myself included, sleep better at night by practicing DCA. Because you always have that voice in your head saying "What if I invest all my money in full today, and tomorrow the market crashes?!?". This behaviour is well explained in pshycology literature, where it is shown that people tend to be risk averse.

    Best,

    DW

    ReplyDelete
  3. DCA sounds nice but as you said not that many people have the where-with-all to consistently invest in the market.
    In my case I usually invest when the major div months come in JAN/APR/JUL/OCT for me.
    As I am in Canada the limitiations of the cash contributions to registered retirement accounts are limited to certain amounts each year.
    Outside of that I let the divs increase within the account, cash position, until there are sufficient monies to make a purchase. Otherwise you may be paying a fairly significant amount in brokerage fees to maintain your position.
    If I want to bite the bullet on a stock then I have a HELOC that I can use to purchase within a non-registered account.
    I stil prefer to make a major purchase rather than chomp at the bit for a whole year.

    ReplyDelete
  4. I agree its nice when you have the money to do this. I read an article proposing this same technique in the mid 2000's and I started to do this as best I could in 2009. Since 2009 I very heavily contribute to my 457 plan at the beginning of the year so I get as close as I can to an early year lump sum (basically I invest using a compressd DCA in the beginning part of the year). I have no match to worry about so I see how early in the year I can max out in my account. This has helped to goose my account just as you describe. This year I will max out in August (I used to max out earlier, but now over 50 my upper limit has increased).

    ReplyDelete
  5. Why not both? I have a fixed amount transferred to my brokerage account monthly that I add at an on going basis, and if I should happen to get any bonuses or windfalls throughout the year I put the entire amount to work right away! Both strategies can have a place in portfolio construction.

    ReplyDelete
  6. I had been wondering what the breakdown was between investing at once vs over time. Personally, I like to invest over time, mostly because that is exactly what my financial situation allows.

    However, if I were to change jobs and roll a 401k into an IRA, I would need to consider both of these situations.

    Thanks for taking the time to discuss this!

    ReplyDelete
  7. Very interesting post...I had no idea that lump sum investing would overall perform better than dollar cost averaging. Either way, I would say that we do a little of both. What has also been working for us is making sure we review and rebalance our portfolio once a year. Thanks for sharing...onward and upward!

    ReplyDelete
  8. Hi DGI, nice article - always good to see some nice, hard data used to make a point.

    It's always hard to draw hard-and-fast conclusions though when there are so many other factors to consider, but is really helpful to get people thinking about what will work for them. I know I always love to put any money I have straight to work in the market, but making sure it goes towards the best value investments I can find that fit well with the rest of my portfolio. It's just impossible to predict what the broader market is going to do, and it saves me a lot of worry about trying to time my investments!

    ReplyDelete
  9. Great article DGI,

    Personally, I like the lump-sum approach as stock market eventually go up over time and I don't want to loose the gaining opportunities, but as you said the dollar cost averaging is works well in difficult time.

    ReplyDelete
  10. I just changed my investing from DCA to lump sum and found that lump sum does some advantages. I bought Unit trusts as well and DCA works best at Unit Trusts.

    ReplyDelete
  11. I assume you've seen Vanguard's research into this topic: https://advisors.vanguard.com/VGApp/iip/site/advisor/researchcommentary/article/IWE_InvResDollarCost

    ReplyDelete

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