Investors & Dollar Cost Averaging

Over a longer time horizon, lump sum investing may outperform dollar cost averaging (DCA). But that is usually relatively long and hard to guarantee given short to medium term market volatility. Results vary depending on the timing of investment purchases. Bit of a crapshoot to say that one way or the other always outperforms.

In 2012, Vanguard conducted a study that found lump sum outperforms DCA about 66.7% of the time after 10 years. Vanguard’s study assumes that you have all your investable capital on day 1. Then you either invest 100% on day 1 or spread your purchases between 6 and 36 months. Lump sum often makes sense in this scenario as over longer periods asset classes historically have shown positive returns. The sooner you invest in higher return assets, the better.

However, there are a few reasons I tend to recommend DCA to investors.

The first is that it is great for small investors.

DCA is Tailor-Made for Small Investors

The majority of investors are what I would consider small in nature. They do not have thousands of dollars just sitting around ready to invest in lump sums should a buying opportunity arise. Except for inheritances, home sales, pension freezes, or lottery wins, most investors have to scrimp and save to maximize their (tax efficient) investment accounts.

So they have two choices.

One, stockpile cash reserves until they reach a critical mass, then buy in a lump sum.

While waiting, always store cash reserves in highly liquid assets that offer a positive return. These include: money market funds; sweep accounts through your broker; short-term Guaranteed Investment Certificates or Term Deposits through your bank. Just watch the costs and ensure there are no penalties for cashing in sooner than the term expires.

Two, purchase investments slowly and consistently over time. Using DCA, or other averaging methods, until reaching the desired quantity.

Had Vanguard done a study where an investor needed to slowly accumulate funds before making that lump sum, rather than having 100% on day 1, their results would be different.

Longer the Delay, the Less Advantage for Lump Sum

The longer the accumulation period needed, the greater the potential variance. For someone without ready investment cash for an initial lump sum purchase, I think DCA may not underperform over time. That is, DCA is the better system.

Steady, Appreciating Market, Go Lump Sum

For example, you wish to invest $20,000 in ABC under either a lump sum or DCA method. Commissions are $10 per transaction. DCA will accumulate shares quarterly during the year. Share price during the year is: January 1, $19.99; April 1, $24.95; July 1, $33.27; October 1, $49.99; December 31, $50.00.

Under lump sum, on January 1 you purchase 1000 shares. The unrealized gain at December 31 is $30,000.

Under DCA with quarterly purchases beginning January 1, you end up with 700 shares and an unrealized gain at December 31 of only $15,000.

A clear win for lump sum investing.

Save Over Time, then Lump Sum, Not as Good

Maybe you do not have $20,000 to invest on January 1. It may take 6, 9, or 12 months to amass that amount. But you wait as you prefer the lump sum approach.

Ignoring rounding and interest income as you save the cash, if you bought at July 1, you would get 600 shares for your $20,000. If you wait 9 or 12 months, you are able to buy 400 shares. At year end, your unrealized gains are $10,000 for the July 1 purchase and $0 for the October 1 or December 31 acquisitions.

Under both these scenarios, DCA outperforms lump sum. The same $20,000 investment nets 700 shares using DCA. However, you only receive 600 shares buying July 1 or 400 shares investing October 1.

Depending on the price change of the asset being acquired and the delay in making the lump sum purchase, DCA may have a much better outcome in performance than with lump sum.

Over Time, Price Growth is Seldom Consistent

And that assumed ABC shares appreciated steadily throughout the year. In reality, especially over multi-year periods, prices rise and fall in the short to medium term. Nor do you tend to see many companies increasing 150% in one year.

Perhaps ABC traded at $19.99 on January 1, 2018. And closed December 31, 2019 at $30.00. A two year gain of 50% on your $20,000 lump sum purchase on day 1. Still quite good.

But let us say that you invest that $20,000 semi-annually over the two years. And the stock traded at: January 1, 2018: $19.99; July 1, 2018: $14.50; January 1, 2019: $17.50; July 1, 2019: $24.00; December 31, 2019: $30.00.

With typical equity volatility, your DCA approach netted 1087 shares with an adjusted cost base of $18.40 per share. A lower cost base than had you paid $19.99 per share using lump sum.

Summary

While empirically a lump sum purchase may often outperform DCA in the long run, I do not take those findings as gospel.

First, the studies indicate that lump sum investing is superior about 66.7% of the time, in the long run. That is not a slam-dunk. Especially if you must wait and save before making that lump sum investment.

Second, while the very long run trend in asset valuations is positive, you may need to wait a very long time. And if you buy in at the wrong moment, you may never fully recover depending on your age. Remember that it took 25 years to fully rebound from the 1929 crash of the Dow Jones Industrial Average.

Third, as we have seen above, the lump sum outperformance assumes an up-front investment. If you need to delay your lump sum purchase due to a lack of capital, the results may differ significantly. The longer the delay, the greater the potential variance.

Despite the empirical data, unless you have adequate cash reserves to invest lump sums initially, I believe most investors should utilize DCA.

We will look at a second reason in support of DCA next time.

How DCA promotes a disciplined and consistent approach to investing.