A topic that seems to come up a great deal is whether you should put a lump sum into an investment or use a dollar-cost average approach. Let's explore what the difference is:
If you have a set amount of money, you can choose whether to place it all into an investment at once, or you could take that amount, divide it by, say, 6 and then do 6 equal investments over a period of 6 months. In both scenarios, you're investing the same amount of money but in one scenario your money is affected faster than in the other.
Back in 2012, Vanguard published an exceptional paper where they compared the historical performance of dollar-cost averaging (DCA) versus lump-sum investing (LSI) across three markets: the United States, the United Kingdom, and Australia. Their study found that two-thirds of the time the LSI approach out-performed the DCA approach.
In this study, Vanguard looked at the US from 1926 to 2011, the UK from 1976 to 2011, and AU from 1983 to 2011. To calculate the average magnitude of LSI outperformance, they calculated the average ending values for a 60%/40% portfolio following rolling 10-year investment periods. In the US, 12-month DCA led to an average ending portfolio of $2,395,824 whilst LSI led to an average ending value of $2,450,264, or 2.3% more. The results were similar in the UK and AU. UK investors would have ended with 2.2% and in AU, 1.3% more, on average.
Let's have a look at the performance of LSI vs DCA:
What I've found most interesting about all of this isn't the fact that a lump sum investment can yield a greater return, it's the emotional side of these investment approaches. If one has a lump sum and invests that lump sum all at once and the market goes down, what is the emotional strain going to be like? I was listening to a podcast the other day (I think it was The Personal Finance Podcast) and the presenter said something along the lines of investing is meant to be done to avoid financial stress, not create it and that resonated with me. We're meant to invest to avoid financial stress, so if a lump sum is going to potentially create a huge amount of stress if the markets go down, then a lump sum investment probably isn't the best move. A more, let's call it a conservative dollar-cost average approach might be best from an emotional point of view. Think of it like this, imagine you invest all of your money and the market drops 5%, you're going to feel highly stressed and a percentage of people may pull their money out for fear of things going down further - that's a 5% loss (and fees) gone just like that.. devastating.
I think what's also important to recognise here is that this all depends on the market's movements as well. Looking back at the past does not mean that's what will happen in the future, so performing that study from now for a few decades might reveal completely the opposite result. Personally, I prefer to dollar-cost average, not completely due to the emotional side of things but also from a cash flow point of view, I don't find lump sums falling in my lap often, haha.
Click here to download the full Vanguard paper if you're interested in reading this in a bit more depth.