Is it better to invest a lump sum of money all at once or spread it out in instalments over a period of time?
Before we tackle the question, let's be clear: If your cash flow is such that you can only make periodic investments, then you have no choice but to invest in stages. For example, some people have money withdrawn monthly to buy mutual funds. Nothing wrong with that.
What we're trying to determine is the best course for someone with a large chunk of cash to invest right now – from an inheritance or bonus, for example.
Fans of dollar-cost averaging maintain it's better to invest gradually. The theory is that, by doing so, they're less likely to put the entire bundle into the market right before a downturn. By spreading out their purchases, they can minimize the impact of a selloff.
While there is some merit to that argument, research has demonstrated investing the entire lump sum produces superior returns most of the time.
In a thorough study, investment company Vanguard Group compared dollar-cost averaging with lump-sum investing over rolling 10-year periods in the United States from 1926 through 2011. The first period examined was the 10 years from January, 1926, through December, 1935, the second was from February, 1926, through January, 1936, and so on until the 10 years ending in December, 2011.
Authors Anatoly Shtekhman and Brian Wimmer also examined data for Britain from 1976 through 2011, and for Australia from 1984 through 2011.
The results were virtually identical for all three countries: Assuming a portfolio with a 60-40 mix of stocks and bonds, the lump-sum approach achieved better returns two-thirds of the time compared with investing in equal instalments over the first 12 months.
"This is really quite intuitive – if markets are going up, it's better to put your money to work right away to take full advantage of market growth," the authors said.
What's more, the longer the dollar-cost averaging period, the higher the probability that lump-sum investing outperformed. If the cash was deployed over 36 months instead of 12, for example, the lump-sum approach won 90 per cent of the time.
However, the authors pointed out dollar-cost averaging does have psychological – as well as short-term financial – benefits.
"Risk-averse investors may be less concerned about averages than they are about worst-case scenarios, as well as the potential feelings of regret that would occur if a lump-sum investment were made immediately prior to a market decline," they wrote.
Indeed, lump-sum investors are more exposed to downside risk in the short term. The authors found lump-sum portfolios declined in 22.4 per cent of 1,021 rolling 12-month periods examined on U.S. markets, while dollar-cost averaging portfolios fell in 17.6 per cent of those periods. But that short-term protection is achieved at the expense of generating higher long-term returns.
"Investors must determine for themselves whether or not reducing their portfolio risk in an attempt to avoid losses and regrets is worth reducing the potential for higher returns," they said.
In his book Debunkery, Ken Fisher, head of U.S. money management firm Fisher Investments, concluded dollar-cost averaging (DCA) "really only helps if you know there's a falling market ahead. And if you could forecast that accurately, what do you need DCA for?" What's more, with DCA there are often higher transaction costs.
Similar to the Vanguard study, Mr. Fisher's firm examined 20-year periods from 1926 through 2009 and found lump-sum investing produced superior returns 69 per cent of the time.
"The reason is simple: More often than not, stocks move higher. You benefit more from being invested more of the time than you do trying to avoid near-term wiggles," he said.