You probably heard the terms dollar-cost averaging and lump sum investing before. Dollar-cost averaging (or DCA) refers to periodic investments regardless of the share price. Whereas lump sum investing refers to investing in one single purchase.
In other terms, DCA is when you have a sum to invest but wait a certain time frame to invest in multiple smaller purchases rather than investing as soon as you can.
- $10,000 invested in DCA would be like investing $1000 a month for 10 months. vs
- $10,000 invested all today would be like a lump sum.
The DCA might be easier since it can be automated and saves you from the temptation to try to time the market. However, studies have shown that lump sum investing has twice the probability of outperforming than dollar cost averaging.
A Vanguard study (see figure 1) made by averaging for 12-months compared to one single lump sum and based on rolling 10-year periods, research showed a 67% chance of outperforming when investing now compared to only 33% with dollar cost averaging.
Past performance does not necessarily predict future results but you are still statistically more likely to finish ahead if investing in one lump sum than DCA. You need to find your own way, the important part is to save, invest and stay constant.
Looking back at historical results
Dollar-cost averaging was first popularized back in the 1980s by many finance book such as David Chilton’s The Wealthy Barber. However, after back-testing the idea, the results show that dollar-cost averaging rarely outperforms lump sum investments.
A 1979 research paper from the Journal of Financial and Quantitative Analysis found that DCA produced higher returns in just 27% to 39% of the scenarios it tested.
However, constantly buying in the market will take off a lot of the psychological aspect of investing. When your investments are falling, it just means you will be buying more shares at a better price.
In addition, if you are risk-averse, dollar-cost averaging does limit volatility. You will reach lower highs but your investments will drop less in times of market swings. With a proper asset allocation, you can enter the market with a steady, periodic, investment approach minimizing your regrets from a loss even if you might not optimize your gains. You need to know what kind of investor you are and find the proper method for your investment style.
What feels worst? Seeing your portfolio drop by 100$ or missing out on a 100$ profit ? If you don’t like drops then a dollar-cost average approach is appropriate for you.
Living paycheck to paycheck (the good way)
Now, there is a difference between dollar-cost averaging and investing every paycheck. When purchasing investments every pay, you are effectively investing as soon as the money is available to you, which is technically lump sum investing.
I use an investing program given by my current employer to automatically invest a portion of every paycheck to maximize the matching contribution my employer offers and to invest as soon as the money is available to me. I also invest my bonus in a registered account the day I receive it to minimize my taxes. Investing all my bonuses in my registered retirement plan (401k) lowers my tax bracket and forces me to keep it invested.
Whether more profitable or not, your worst bet, over the long-term, is not being in the market at all. Automating your investments prevents you from forgetting to invest. It might be the perfect solution depending on your person.
The double edge of investing first is the budgeting aspect it brings to your finances. Reverse-budgeting is setting a fixed amount of your budget for savings and living off whatever is left. I force myself to live paycheck to paycheck. I just have half my income to live off but this strategy greatly accelerates our savings. It can be hard at first. However, it is a really effective way to quickly pay off debts or increase your savings rate drastically.
Don’t save what is left after spending; spend what is left after saving. – Warren Buffett
In addition, if you work for an employer that matches part of your contributions, you should definitively take those free dollars. Many 401k or employee stock option programs offer an employer match. I, for example, get 50¢ to the dollar if I invest in my employee stock option. You should definitively max out those accounts since you will always be better off with all that free cash to invest. Those matches are usually done every pay so in that case, you would be optimizing your returns by investing as soon as possible.
Where to invest?
If you found an investment strategy that works for you and you are ready to invest, stick to it and stay consistent. I suggest you invest a portion of your pay automatically into index funds and take a look at my investment suggestions to choose a proper asset allocation for your objectives. You can also see exactly how I invest in my Open Book series.
- Bennyhoff, Donald G. Emotional Circuit Breakers: Equity Implementation Plans.
- Chilton, David. The Wealthy Barber
- Constantinides, George M. A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy.
- Gerstein Fisher & Associates. Does Dollar Cost Averaging Make Sense For Investors?
- Malkiel, Burton G. A Random Walk Down Wall Street.
- Rozeff, Michael S. Lump-Sum Investing Versus Dollar-Averaging.
- Williams, Richard E., and Peter W. Bacon. Lump Sum Beats Dollar-Cost Averaging.