An influential study shows the best returns come from putting a lump sum of money into the stock market rather than investing a bit at a time.
But do we really have to follow this rule right now, with the stock markets looking peaky after a long run higher? I said no in a recent online column, but the people who wrote that study thought the topic worthy of further discussion. So I sat down with one of them recently to talk about lump-sum investing versus dollar-cost averaging. As it turns out, the guy I spoke with wasn’t sure he’d put a lump sum into today’s market.
Paul Bosse, a principal in the investment strategy group at U.S.-based fund giant Vanguard, said he actually uses a form of dollar-cost averaging himself. Others might call it a regular investing program, but basically it means investing a set amount when he gets paid. Next, I asked him how he’d invest a lump sum if he had one at hand.
“I’d have to think about it,” he said in an interview while passing through Ottawa. “It would feel kind of squirrelly to put it all in right now. But I know that studies just like ours argue that you should do it right away.”
The Vanguard study he’s referring to is quite clear in saying that lump-sum investing achieves better returns than dollar-cost averaging. “If you’re looking for wealth maximization, you want to get into the market as soon as possible,” Mr. Bosse said in summarizing the findings. “You don’t know where the market is going, but we know that two-thirds of the time it’s going to win.”
In a column I wrote last month for Globe Unlimited subscribers, I said investors should ignore this finding if they have money to invest in stocks, but are nervous that a market correction is coming.
“We, like you, feel that if people are nervous, if they’re concerned about the risk of loss, then dollar-cost averaging makes a lot of sense,” Mr. Bosse told me. “It gives them fortitude if the market goes down – ‘thank God I didn’t put all my money in.’ And if the market goes up – people can say,‘thank God I put some money in.’”
Here’s another reason to consider dollar-cost averaging right now: Even Vanguard says it performs better in market downturns. “DCA may be a logical alternative for investors who prefer some short-term downside protection,” the firm’s study says.
Lump-sum investing does seem ill-suited to a stock market that has climbed steadily since bottoming in March, 2009, but let’s give this approach its due. In its study, Vanguard compared dollar-cost averaging with lump-sum investing in the U.S., U.K. and Australian markets and found that better returns were generated by the lump-sum strategy roughly two-thirds of the time.
The study looks mainly at 10-year returns from portfolios with a weighting of 60 per cent for stocks and 40 per cent for bonds (other asset mixes were also examined – see chart). For dollar-cost averaging, it was assumed the portfolio started out completely in cash and was gradually transferred into a diversified portfolio over 12 months. For the lump-sum investment, the money was invested in a diversified portfolio for the full 10 years.
The comparison was repeated over rolling periods of time, which means it reflects all kinds of market conditions. The first slice of U.S. data went from January, 1926, through December, 1935, the second from February, 1926, to January, 1936, and so on, right through to the 10 years ended December, 2011.
The full results are remarkably consistent in the three markets tested. Over rolling 10-year periods, the lump-sum investment for the stocks and bonds portfolio produced better results 67 per cent of the time in the U.S. and U.K. markets, and 66 per cent of the time in the Australian market. The amount by which the lump-sum outperformed is significant, though not mind-blowing. In the U.S. market, the lump-sum portfolio ended up 2.3 per cent higher than dollar-cost averaging over a 10-year period on average; in the U.K., the margin was 2.2 per cent and in Australia it was 1.3 per cent on average.
The investment industry likes dollar-cost averaging because it’s easy to understand and attuned to the needs of cautious investors who otherwise might shy away from the equity funds that generate the most fee revenue. One mutual fund firm says dollar-cost averaging is “right for all markets” on its website. Another financial firm says, “For many investors, dollar-cost averaging may be one of the simplest ways to accumulate savings over time.”
There is a strong behavioural argument in favour of dollar-cost averaging and it goes like this: If you don’t expose yourself to the risk of making a lump-sum investment before a stock market correction, then you reduce the chances that you’ll give in to regret and sell at a market low.
Dollar-cost averaging also gets you moving – you’re no longer idling on the sidelines watching the stock markets move higher without you. The more gains you miss out on, the greater the risk that you’ll give in to regret and buy at a market high.
But there’s a behavioural weakness to dollar-cost averaging, too. You might say you’re going to invest the cash sitting in your account every month or quarter, but will you? You might decide to back off if stocks fall hard, in which case your money will remain longer in cash, which returns next to nothing right now, or bonds, where returns after inflation are next to nothing.
Suggestion: Make a one-year commitment to dollar-cost averaging if you have a lump-sum amount sitting in cash in your account. If commissions aren’t a concern, then invest monthly. If they are, try quarterly. But aim to have your lump sum fully invested 12 months into the future. Vanguard’s research shows that the longer you extend your dollar-cost averaging, the more the lump-sum option outperforms. In the U.S. market, a 36-month program of dollar-cost averaging was outperformed by a lump sum 90 per cent of the time.
There’s some urgency to the question of whether to use dollar-cost averaging or lump-sum investing. Money sitting in cash right now is safe against loss, but useless in helping you build a portfolio that will help achieve your financial goals. Most of us need stocks in the mix for optimum investing results, and not just a small weighting.
So take your time moving that mountain of cash into the stock markets, but not too long. Vanguard’s Mr. Bosse said it all comes down this question: “How quickly do you want to be involved in the outperforming asset?”Report Typo/Error