When considering whether to invest with a lump sum or dollar cost average into the market, the most important thing to remember is that nobody knows where the market will be in one year, two years, 10 years, and even if they did, it wouldn’t even matter….
Today I am talking about whether it’s better for you to invest a lump sum into the stock market or drip feed your money in gradually in order to get yourself the best returns for your investment.
Dollar Cost Averaging?
Drip feeding your money in gradually is known as dollar cost averaging but this could just as easily be pound cost averaging, euros, yen, whatever! It’s just a term for spreading your investment over a period of time rather than dumping it all into your investments in one go.
I’m going to talk about whether DCA or Lump sum investing is likely to make you more money, some things to think about when deciding what to do with your money and finally some discussion on what might be better for you depending on your own goals.
Remember none of this is financial advice, it’s just chatter from a guy on the internet who does a bit of investing himself understands numbers and probability and stuff like that pretty well. Take this info as you will, and speak to a professional if you need real, actual advice.
Historically, lump sum offers better returns
I’ve seen lots of chat on the web about what the best thing to do is – whether to lump sum invest or dollar cost average and there are strong advocates for both.
I can tell you with absolute certainty that history shows it’s better to dollar cost average. And I say history there, because nobody knows the future. And we will come back to this somewhat inconvenient fact in just a minute.
Vanguard’s Research
Vanguard published a fantastic piece of research in 2012. Vanguard (in the unlikely event you have found this video without know who Vanguard are) offer one of the most popular investing platforms in the world holding more than for 30 million people. It’s a wonderfully titled production called “Dollar-cost averaging just means taking risk later”. In essence they they looked at three different markets – the UK, the US and Australia, looking at rolling 10 year period from the 1920s right up to 2011 and for investing periods ranging from six months to three years. That is a pretty large sample to make some interpretations from the data that they found.
And what they found was this: that around two thirds of the time you would be better off with a lump sum over dollar cost averaging with the same amount of money.
Not all the time! But two thirds of the time, and remember this is across all the time spans they looked at, across all markets – that’s over 1000 time periods, you would be better off just getting as much as you can into the market as early as you can, instead of spreading spreading out your investments.
Now, obviously that’s not to say that if you don’t have a lump sum you shouldn’t invest what you can regularly. This is to say that given a choice of lump sum investing say £20,000 or spreading that 20k at £1000 deposits over 20 months then ⅔ of the time you will be better off lump sum investing.
So for all those folks who like to wait for a dip, two thirds of the time you wait for that dip, you are going to be worse off.
Now there are times when you as a person will want to dollar cost average in – there have been times when I wanted to do it too. I’m not telling you it’s wrong to do that, I’m just presenting facts that historically you will be better off two thirds of the time just getting your money in.
There are often very good reasons for wanting to DCA I will return to those later, but for now, we must accept what the data says and understand we will be better off, two thirds of the time if we get our lump sums in.
It just makes sense, from a mathematical point of view
And that makes sense to me, even on a superficial level because if we consider why we are all invested in the market in the first lplace, it’s because we understand that on average we would expect it will return us somewhere between 7-10% per year depending on how you invest and so as the months go by, on average, the market is going to get more expensive. I don’t need vanguard’s research to tell me this, although it’s nice to have these sorts of papers to point to to back up an idea.
So if prices are steadily rising over a long period of time, Why wouldn’t you want to have your money in at the earliest opportunity?
And I know what protests some people will make about this. Even though what I said there is mathematically sound, the doubters will say you shouldn’t lump sum invest because the market doesn’t move in a straight line.
That is 100% correct! It has ups and downs, day by day, week by week, month by month… you get the idea, but the inconvenient fact I mentioned earlier about nobody knowing the future, means nobody knows when those short term dips or sharp rises are coming. You can’t possibly time your buying points perfectly. If you do get one or two right, let’s be honest here… it’s more down to luck than anything else that your buy in point was at the lowest it could be. By averaging, you are just as likely to be buying at a high price as you are a low price.
So one thing to remember is that nobody knows where the market will be in one year, two years, ten years, and even if they did, it wouldn’t even matter, because we don’t know the journey the market will take to be at that level.
Dollar cost averaging could mean you could miss out on huge rises if the market takes off in the first half of the year meaning that you would be dollar cost averaging into a losing position if it were to come back down again towards the end of the year.
Next week’s lows (the dip) could still be higher than today’s highs.
The fact remains, no matter what all the investor news says nobody can predict the future, and it shows based on the fact that most fund managers can’t beat the returns of the market.
So if we accept we can’t beat the market, and we accept that two thirds of the time we are better off by investing as much as we can as early as we can then why would anyone dollar cost average?
The case for DCA
Well as I alluded to earlier, there are good reasons. The biggest one is that while you give up some potential gains (two thirds of the time) by not DCA you also decrease the risk of losses.
Vanguards research uncovered that you will lost money lump sum investing about 22% of the time while DCA would see you lose money around 17% of the time.
By spreading our money over a longer period of time we can reduce the volatility by buying in on a regular basis meaning we are much more likely to cover a range of market conditions as time goes by.
Humans are typically risk averse. There has been some superb research in this area and it’s really interesting how we as people are naturally more concerned by what we could lose rather than what we can gain. Our decisions, whether we like it or not are naturally influenced, by what we could lose even when we know there is potentially more to gain. DCA helps mitigate that risk of market swings going against us as time goes by.
As I say, all this is backed up by that same research from Vanguard I quoted earlier. Lump sum investing lost money just over 22% of the time, whereas DCA lost money around 17% of the time. So if you are the sort that would much rather try to make sure you keep as much capital as possible then DCA might help you sleep a bit better at night.
Investing can be a very emotional thing, so if you are the sort to stress on your investments and short to medium term volatility then DCA might be a better bet for you. It allows you to invest regularly without paying too much attention to the market at a given point in time, because you will be averaging in consistently, whether things are particularly high or particularly low, and you will be riding that gradual upward curve if everything goes to plan.
If you were lucky enough to come into some money to invest you would do well to consider how you will feel about having a large sum of money (large in relative terms of course) invested in the market where the longer you can leave it alone, the more likely you are to see decent returns. You should give some thought as to how you will feel emotionally watching that money fluctuate on a day to day basis.
It’s ok if that worries you, of course! It’s just another reason to help you consider the best approach for you. Personal finance is of course, personal!
However over the long term, stock market returns have been shown historically to outpace the growth of cash holdings, so you would also have to consider the potential cost of leaving money on the sidelines.
It’s not easy! And there definitely isn’t a one-size-fits-all approach.
To step back slightly, I don’t think that the difference for most people will be that big. The average guy or gal out there who is investing a portion of income each month is not likely to be sweating on a percentage point here or there, and while the maths may fall on the side of lump summing everything you can, a good night’s sleep is definitely more important.
For me personally, I started my investing in the stock market with as much as I could must in October 2019 which was just shy of £6000 and that was just a few months before the pandemic took a chunk out of the market, but then I just invested as much as I could each month, and as the markets recovered to new all time highs, I got the benefits of just investing consistently with as much money as I could must each month.
There is no wrong approach when it comes to investing in real life.., find out what works for you and commit to it.
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Comment below to let me know your investing strategy and how you are doing. Thanks very much for reading, I’ll see you in the next one!