Coming off a record-breaking year in North American equities – the S&P 500 produced a total return (including dividends) of 31.5 per cent in 2019 and the S&P/TSX Composite advanced 22.9 per cent – investors with new assets to put into the market might be wary of plowing them in at this point. Given the commonly cited options of 1) investing all at once, 2) investing a bit at a time, and 3) waiting for the market to correct then buying in, the choice of when to invest, let alone what to invest in, might not be intuitive.
For long-term investors, Option 3 is an unrealistic one. The market may rally for extended periods without a correction and very few can time the market precisely. As markets have historically trended higher over long time frames, it makes little sense to try to predict when markets will reverse.
The choice between Option 1 (investing a lump sum all at once) or Option 2 (known as dollar-cost averaging) may not be as obvious as it seems. To many, dollar-cost averaging may intuitively seem ideal as it spreads out the cost of purchase over time. To add clarity to these common paths, my Morningstar colleagues Paul Kaplan and Maciej Kowara published a study titled Dollar Cost Averaging: Truth and Fiction in which they compared the results of lump-sum investing and dollar-cost averaging in the S&P 500 index, on a total return basis, using data spanning back to 1926. In this study, they measured the percentage of the time that dollar-cost averaging delivered more wealth to the investor than lump-sum investing over periods spanning from two months to 10 years. It was found that most of the time lump-sum investing provides more financial wealth. Dr. Kaplan and Dr. Kowara were kind enough to provide me with the same analysis using the S&P/TSX Composite Index, going back to 1956.
The chart illustrates that if one were to invest all at once versus investing half the assets in Month 1 and half in Month 2, only 39 per cent of the time does dollar-cost averaging result in more wealth than lump-sum investing (testing all the two-month periods between 1956 and 2019). The percentages taper off significantly the more months you spread out the investment. For example, if you had spread out the investment evenly over 24 months, only about 25 per cent of the time does dollar-cost averaging result in more wealth than lump sum investing in that period (again, testing all 24-month periods between 1956 and 2019).
Intuitively, this should make sense. If markets trend up over the long term (as the S&P/TSX Composite has done over the past 60 years), the longer you stay out of the market in cash, the less you will end up with at the end. In terms of the magnitude, the chart below illustrates the ratio in final wealth between dollar-cost averaging and lump-sum investing.
Over two months, the difference is negligible between the two approaches. Over 120 months, dollar-cost averaging yields just 68 per cent of final wealth compared with lump-sum investing, on average.
Further to this point, Dr. Kowara and Dr. Kaplan also authored a separate article outlining what they deem as “critical months” of performance for an actively managed mutual fund. Critical months were defined as those whose removal would be detrimental to the fund’s outperformance over its benchmark. Of the 304 Canadian domiciled equity funds analyzed over the 15-year period between November, 2003, to October, 2018, there were, on average, only 7.8 critical months. Not being invested during these months would put you on par with the fund’s benchmark index. A phenomenon not just relevant in Canada, but globally. In the United States, as an example, the same study showed that there were, on average, only 6.4 critical months over the same period.
The bottom line: No one can predict what those few, critical months are, which is another excellent argument for staying invested – you’ll be sure to catch those months when they occur.
Most seasoned investors will agree that investing early and staying invested is what will ultimately help you toward your financial goals, two objectives that are easier said than done. For the risk-averse, the above data seek to provide some comfort in investing new assets after the market’s terrific performance in 2019.
Ian Tam, CFA, is director of investment research for Morningstar Canada.