Dollar-cost averaging vs. lump-sum investing - August 23, 2022

Dollar-cost averaging vs. lump-sum investing
We have fairly often underlined the deficiencies of market timing in our blog. In an effort to reduce the risk of market mistiming and mitigate the impact of volatility, some investors apply dollar-cost averaging. Dollar-cost averaging means investing the same amount of money at regular intervals over a certain period of time, regardless of price. This strategy eliminates the burden of trying to buy at the best price. The purpose of dollar-cost averaging is to avoid the risk of investing a large amount at a potentially unattractive price.

The reasoning behind the strategy is quite simple. Rather than investing a certain amount of money immediately, an investor may try to avoid potential loss from poor market timing by investing that amount over time. Here is an example. Suppose you invested 10,000 dollars in the S&P 500 Total Return (which takes into account the dividend distributions) index in August 2008. Ten years later you would have almost 17,650 dollars more. However, if you invested 833 dollars (which is 1/12th of 10,000) each month during 12 months starting in August 2008, your profit would be nearly 28,000 dollars in August 2018. Quite impressive. But does it always work? 

Our analysis is based on investing in S&P 500 Total Return index in the past 35 years. For lump-sum investing, we assume that $10,000 is immediately invested into a portfolio of equities and then held for a period of 1, 3, 5, or 10 years. For dollar-cost averaging, we assume that the same sum is invested in equal amounts into a stock portfolio over a period of 12 months ($833 per month) and then remain invested through the end of the year 1, 3, 5, or 10. We have found out that the lump-sum investing outperformed the dollar-cost averaging in roughly 80% of the cases. The ratio is practically the same across all investment horizons examined. Therefore, our conclusion is that history favors lump-sum investing. A more comprehensive study published by Vanguard in 2012 also came to the conclusion that the lump-sum investing outperformed the dollar-cost averaging approximately ⅔ of the time. On the other hand, according to the study, dollar-cost averaging can reduce the risk of loss. 

This in no way means that it only makes sense to invest if you already have a large amount of money. In fact, investing smaller amounts of money at regular intervals has its advantages. We have also looked at investing into equities of equal amounts every month over a period of 3, 5, and 10 years, during the entire period of time. We have found out that the probability of loss was lower with the monthly investments (see Chart 1).

Moreover, the rate of return was higher with the monthly installments compared to the lump-sum investing. 

The bottom line

If you are pondering whether to invest a large amount at once or to invest it in equal installments over time, historical evidence suggests that you should invest the entire amount at once. This certainly does not mean that you should postpone investing until you have a large sum of money for this purpose. In fact, investing smaller amounts of money at regular intervals also has its advantages, such as minimizing downside risk. The truth is, the earlier you start investing, the better.

Disclaimer: This analysis is for general information and is not a recommendation to sell or buy any instrument. Since every investment holds some risk, our main business policy is based on diversification to minimize threats and maximize profits. Innovative Securities’ Profit Max has a diversified portfolio, which contains liquid instruments. This way, our clients can maintain liquidity, while achieving their personal investment goals on the long term.