What do you do if you have a large lump sum you need to invest? Do you spread the payments out and drip feed them into the market?
Do you worry about putting all your lump sum to work immediately, only to experience a market crash and lose a chunk of it immediately?
I bet.
I was the same.
That was until I read a paper by Vanguard that back-tested the comparison of a lump sum strategy with a dollar-cost averaging strategy using historical data. It showed that investing all the lump sum immediately is often more optimal that spreading the payments over a period of time. This completely changed the way I thought about drip-feeding my money into the market and I now invest all in one go.
It’s also a pretty obvious result, but as I find with so many things, it wasn’t obvious to me until I had read some research and then done many hours of my own research. So what better way to welcome 2018 than with some analysis on a topic that I think will be useful to many!
Before going any further you need to read the important notes.
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Lump Sum or Dollar Cost Average investing? Vanguard’s Paper
Vanguard’s rocket scientists looked at investing in a 60% Equity / 40% Bond portfolio with either a single lump sum at the beginning of the year, or 12 equal monthly installments over the year. They then calculated the rolling 12 year results from 1926 to 2015 and compared the end of year values and calculated two key measurements:
- How many results produced a “win” for the lump sum strategy?
- What is the average outperformance for the lump sum strategy?
In their paper they call the two strategies “Immediate” and “Systematic”, but I’m less fancy and will call the strategies “Lump Sum (LS)” and “Dollar-Cost Averaging (DCA)”.
Near the beginning of the paper there is a curious throwaway comment about looking at different periods, such as 6 months and 36 months, but very few details about this aspect. They also look at the UK and Australian markets and different equity/bond mixes. For both variations they find very similar results.
My Investigations
So what have I brought to this party in terms of new research?
- Extended the historical period to 1802-2015,
- Changed from monthly to annual payments,
- Varied the projection period from 2 years to 30 years,
- Looked at some specific historical periods,
- Also looked at different equity/bond mixes
- I use real returns that take inflation into account. This is important over the long periods I am investigating, but less so for the Vanguard analysis, and it looks like their returns are nominal (i.e. no inflation).
Are you excited to get into the details? I know, me too!
Who Wins? LS or DCA?
Let’s first look at a 100% equity portfolio and compare a LS with a DCA strategy over a 10 year period. Essentially, we are looking at the difference between investing $100 on day 1 compared with investing $10 each year for 10 years.
We find that looking at all rolling 10 year periods from 1802 to 2005 the LS strategy will win 88% of the time. That is a significant advantage to LS over DCA. Moreover, the average outperformance of the LS over the DCA strategy is 2.6% a year. If you wish, you can think of this as a “return drag” of using a DCA strategy, and it’s significant.
But averages don’t really reveal much, the really interesting insights lie in the cracks between the averages, so let’s dive in a bit deeper and look at the outperformance of LS versus DCA for all the starting years of projection. The following chart shows this.
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When Does DCA Win? The Great Depression!
In the above chart I’ve highlighted two periods where DCA wins big time – The Great Depression and Stagflation in the 1970’s. If we look at the equity markets in the 10 year period beginning 1928 we see the problem – see chart below.
You can clearly see that a lump sum invested just before the market crash would have lost money for years (in real terms) and at the end of the period bounced back to roughly par. By drip-feeding your investment you could have mitigated this impact.
However, another lever exists to mitigate this impact and that is asset allocation. Simply diversifying into bonds would have eliminated the impact of the Great Depression on a LS versus DCA strategy. The following chart shows the outperformance of a LS versus DCA strategy on a 50% equity / 50% bond portfolio. You can see that the under-performance of the Great Depression period has vanished, but the 70’s Stagflation under-performance remains.
You can understand this better with the next chart that shows the performance of the bond market in addition to equities through the Great Depression. Check out the bonds – they killed it! Even though equity investors had a really rocky-ride, bond investors enjoyed a steady year on year improvement.
So when you hear about diversification of asset classes and the benefits of using bonds, this is a good case study!
But let’s now go back to the 1970’s and face the ugliness of Stagflation!
1970’s Stagflation
Did you notice above that when we diversified the portfolio into 50% equities and 50% bonds the LS strategy still underperformed the DCA strategy during the 70’s? You might have thought that was due to the dubious dress-sense and hairstyles of the 70’s, but no!
Where were the much-trumpeted benefits of diversification? Let’s look at equity and bond performance through that period.
Urgh! Have you seen anything so ugly!
Over ten years (ten years!) the equity and bond markets fell in real terms. You would have lost money over that period whatever your asset allocation. So you can see that a LS strategy loses to a DCA strategy over this period. The Irrelevant Investor has a good blog article on this time period, called “The worst Bear Market That Nobody Ever Talks About”.
Thankfully you can see from the outperformance charts above these ugly historical periods are few and far between and LS wins almost all the time (or at least 88% of the time).
Different Projection Periods
So what happens when we change the projection period from 10 years? Let’s now look at different projection periods from two to 30 years. As before we will look at all rolling periods from 1802. Just to keep things spicy we’ll also look at varying the asset allocation and consider portfolios that have 0%, 50%, 60% and 100% equity.
The following chart shows the proportion of cases where the LS strategy wins. (Honestly, I didn’t need to say that, since the title of the chart says it, and you’re a smart reader, but it’s a groovy chart huh?)
I think this chart is fascinating. It shows that for any investment strategy the LS strategy dominates DCA, but for periods over about ten years a LS strategy is more effective over 90% of the time (for equity-heavy strategies).
What’s nice is that for very short projection periods my results agree with Vanguard. Remember they looked at monthly payments over a twelve month period and my shortest period is two years, but it’s pretty cosmic-Zen that they agree.
You can also see the benefits of time on your investment. If you are investing over long periods then there is much greater certainty that you will benefit from a LS, rather than DCA, strategy. The mean reversion of long term equity returns is unrelenting, you can’t afford to be out of the market for long.
Did you notice the weird looking line of the 100% bond portfolio above? It looks very different to the equity portfolios, and with good reason. Bond returns over long periods tend to be driven by inflation, whereas equity returns over a long period are relatively immune to inflation. But even with a portfolio that is very heavy in bonds the LS strategy wins a large proportion of the time.
My Advice
What do I recommend? Based on historical evidence from my research and Vanguard’s research it pays to be invested in the market on day one. Don’t drip feed, don’t be timid, you will be wrong more than a third of the time.
Potential Limitations
This analysis and Vanguard’s before it, is dependent on historical experience and is only useful to the extent that the future reflects the past. Vanguard also performed the analysis in the UK and Australia and drew the same conclusions, however I wonder what would have happened had they looked at the lost decades of the Japanese experience? The conclusion may have been different. There is also survivorship bias, in other words this analysis would look quite different during the hyperinflation of the Weimar Republic!
If you believe in a future with economic growth of real GDP then I think these results hold and you should be fully invested in the market and not dollar-cost average. Whether this continues in the future, who knows? But there is a huge weight of historical evidence for mean reversion of equity returns.
Now go on to read Part 2!
Do you dollar-cost average your investments into the market? Have you changed your mind about this like me, or do you continue to dollar-cost average your investments? How excited are you at Part 2 of this post on a scale of 1 – 10? Comment below and let me know what you like, didn’t like, and what you would like to see more of. Thanks for reading, I really appreciate it.
If you want to read some other number-crunching posts why not look at Reprise! Sequence of Returns Risk or College Investing Strategies. Want something less number heavy? Then try Bitcoin: My Best and Worst Investment. My friend and fellow blogger ERN has also written about this subject here.
It’s very hard to overcome the psychology of wanting to DACA over lumps sum. As in most things financial the best math approach requires ignoring instinct. Even knowing this I still catch myself doing it from time to time.
Yes, psychology is such a key part of investing and personal finance. What surprised me with this analysis is the sheer magnitude of the advantage in LS. It’s not occasionally best, its almost always best. And the return drag from DCA is huge. That information should trump instinct, and I think it has for me now.
Thanks for reading FTF!
Fascinating. Most of our investments end up being DCA due to the fact that they are tied to our paycheck so they are invested at regular intervals automatically. Very good food for thought though…
Yes, that is so true. We don’t get paid as a big lump sum at the beginning of the year, so most people forced into DCA. I actually get a bonus each year and so should be lump-summing that puppy straight into the market. Thanks for coming by AR!
Great analysis and detail, Actuary on FIRE. I like to think of it terms of asset allocation. If you have a bunch of cash sitting on the sidelines waiting to DCA, by definition you’re underinvested relative to your target allocation. Unless the amount is so great that it changes your risk tolerance, it seems odd to me that you would follow the same allocation as before.
John – so true. Vanguard made that point in their paper. If cash is not in your asset allocation then why hold it as part of a contribution strategy? The only reason would be if you are making market calls, and most people would not feel proficient in that area.
Thanks for coming by!
*wouldn’t follow the same allocation as before.
Great post! I really enjoy your analyses. As Adventure Rich points out, its very hard for the average person to lump sum invest. One interesting observation is that financial news pretends that you lump sum invest 🙂 This means that all the news we hear or read talks as if each dollar was invested on day 1 of a given year. This isn’t actually true.
Looking forward to part 2!
Yes, that is true about the news. Lots more analysis on a variety of topics throughout 2018 – so stay tuned. Thanks for coming by.
This is pretty much the same findings we got after researching the subject. I like how you analysed the Vanguard study, Thanks.
Thanks for stopping by OFP
When I sold my company and had a large amount to invest, I put it all in as a lump sum. In that case it makes total sense to me. What doesn’t make sense is when people pause their monthly contributions so they can build up a lump sum and try to time the market. I’ve seem this work against them way to many times. When there is monthly money to invest, I say invest it right away and consistently.
Oh yeah market timing is a whole another thing. ‘Buy the dips’. Whatever that means…
Excellent post, I love it when people really dive into a topic. I personally find that I do a bit of both. I do DCA with my regular paychecks and then I do lump-sum investments whenever I get a bonus or need to roll over a recently-exited investment. I suspect most people in finance/consulting are like this.
11! That’s how excited I am for part 2!
For most, I also say do whatever it takes to get the job done. It’s the “you gotta be in it to win it” that’s the biggest barrier to wealth. Then, If you’re more of a math nerd, go with the numbers and do lump sum. But if you feel better when you have a systematic, consistent approach to your investments, then DCA makes sense.
’11’!!! Wow, I now have performance anxiety for part 2!
You’re right, doing something is better than paralysis. This analysis is just gravy – but do something!
If only a lump sum would fall in my lap. Thanks for letting me know what to do with it should I get lucky enough for it to happen!
oh yeah, it’s nice to have a lump sum! Here is to keeping fingers crossed!
Fascinating.
When you buy a portfolio you are buying return AND risk. DCA investing when a LS strategy is available is a form of risk aversion. It is not the same as DCA from your monthly paycheck. Investing paycheck to paycheck is LS investing since you are investing all available funds every month, whereas sitting on a couple hundred thousand is risk aversion, and it costs you return and it costs you compounding. Compounding on the average is the single most important vehicle to being rich in your dotage and if a dollar is not participating in compounding it’s not making you rich, unless you are intentionally using that dollar for insurance. Investing is about buying into being an owner both stocks and bonds as both are forms of ownership.
The problem with your stagflation analysis is you are not diversified. There is a portfolio called the Harry Browne Permanent portfolio and that portfolio weathered stagflation just fine. The reason is that portfolio held gold. This is the reason I hold some gold.
https://seekingalpha.com/article/3206326-kiss-retirement-portfolio-harry-brownes-permanent-portfolio
This link has a chart toward the bottom which looks at how 3 portfolios performed over a long time. Portfolio 1 is the HBPP. Notice how a more proper diversity also known as efficient frontier investing protects the portfolio. The HBPP is probably not the ideally diversified portfolio in terms of percentages but it shows how non correlated diversity saves your portfolio. The downside is it’s rate of return over decades is less but its draw down in bad times is also WAY less. It pays off but it only pays off if you stick to it and are not flipping in and out of it as an investing style.. Flipping in and out constitutes market timing.
It all depends on how you consider a retirement portfolio. I depends if you look at a portfolio as something to provide you the MOST money or to provide you adequate and comfortable money with low risk. These are different constraints.
Looking forward to #2
Completely agree with your first paragraph. DCA when a LS is available is simply introducing lots of cash into your strategy.
I also agree my portfolio diversification illustration was simplistic, but I don’t love the HB portfolio. The 25% cash makes me very nervous, and even I would balk at 25% long Treasury bonds for accumulation phase. I’m also not convinced by gold, or commodities in general – always seems to be a crapshoot. A similar portfolio is Ray Dalio’s All Weather Portfolio. No cash and a lower commodity allocation which makes me a bit happier.
Your last comment deserves a blog post by itself. The FIRE community is driving very hard and fast through the accumulation phase with 100% equities (on the whole) but not much discussion about asset allocation through a long retirement. For the super-early retirees they will need a large exposure to the equity risk premium to drive a reasonable withdrawal rate, but the risk can be managed with some of the other asset classes you suggest.
Thanks, as always.
The HBPP was just an example of a different non correlated risk strategy. I’m not suggesting it though I think it has attractive insurance.
Fascinating study! Prior to reading tis, I thought dollar cost averaging was the way to go.
Thanks PMM, glad you found it useful! Thanks for swinging by.
So I take this article to mean-I was right! Lump sum for the win! PS I may have read that same Vanguard paper a few years ago.
Yep – moms are always right!
Thanks for visiting!
I knew the conclusion before hand, but haven’t read an in depth analysis like this.
Thanks for dropping by, I know you are busy (mom)! 😉
Very cool takeaway. I’d always thought DCA was the way to go until recently as well. After reading The Simple Path To Wealth, he also poses this same argument (but with much less elaboration). Really interesting to see how asset allocation impacts the comparison as well!
I really should read that book. I enjoyed your list of books, and I need to look at that a bit closer. https://minafi.com/favorite-books-of-2017/
Thanks for stopping by Adam
This advice is really timely, because I’ve been wondering when it makes more sense to invest–beginning or end of year. Based on your advice, beginning of year should win almost every time. Some of our investments are Mr. ThreeYear’s DCA 401K contributions, but I can contribute to my i401K any time and in any amount (up to $18.5K of course) so I’ll probably throw as much cash as I can at it at the beginning of the year then “pay myself back” slowly over the year. Thanks for the great analysis!!
Laurie – you’re right, get it all in at the beginning of the year. I’m so glad this was of some help to you. Stay warm!
I’m a lump sum guy all the way. The clear exception I see is dependent on when you want to use the money. If I’m looking at a shorter horizon for when I’ll need the money, I’ll seriously consider alternatives to putting it into the market in a lump sum right away. If you are looking at 10+ years before you need the money, I’d go with a heavy equity weighted lump sum.
You’re right, the one exception to LS might be if you have imminent payments that are required over a short horizon. Thanks for stopping by Jason
Dollar cost averaging is simply a disciplined form of market timing. But it is still market timing… and therefore a losing proposition, as every study since the beginning of time has shown. The only argument I have heard that might make sense for DCA is that it might optimize some investor’s “investing utility” (even if it doesn’t maximize their investment dollars). If LS investing results in investor stress or anxiety, that stress has negative utility associated with it, and therefore DCA may lead to higher utility for some clients. Put another way, they might lose less sleep with DCA, and the client may put some value on that.
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Nice job on the research. My normal course of business is to dollar cost average with every paycheck. If I received a windfall, I would follow your advice and just blend it into my asset allocation. My current asset allocation is 65/35. For example, would not want to hold onto a pile of cash that might cause my allocation to become 50/50.
So true – DCA just tilts your asset allocation to cash.
Great in-depth and informative article. What about the difference in returns when either LS or DCA won? In other words, was it close when LS won but a landslide when DCA won? Or vice versa? Curious if that was analyzed. Because at the end of the day, DCA is a defensive strategy used to minimize risk. You may sacrifice some return, but you will also minimize the chances of a quick and potentially catastrophic loss of principal.
Lump sum may make more sense after a major pullback, such as when the market is near 52 week or multi year lows. But when the markets have set more all-time highs in one year than any other year in history, I’d be hesitant to put a lump sum to work all at once. Stocks keep setting records and interest rates are still near historical lows.
Also, maybe 10 years to DCA a lump sum is too long. But the results are closer using 2 years. You can even do something like 18 months.
The jagged blue mountain chart shows you the level of outperformance of LS versus DCA. You can see that it is really variable. Also Part 2 I looked at the outperformance and measuring that.
You are right 10 years is not a realistic time period. I was really trying to extend Vanguard’s work and see how far I can push it and whether it still held true. Seemed interesting enough to hit publish… Thanks for stopping by!
I always just invest right away. Easier for me to say as I am still in my 20s.
Emotionally if I received an inheritance that was very large I would DCA. This way I could sleep at night while I entered into the market.
Yes, don’t ignore the emotional aspect of this. It’s important.
Awesome post!
There are soooooo many opinions on DCA and LS. You break down very nicely the distinct advantage to LS, and I definitely side more with LS. My fiancée and I knock out our IRA’s within the first 4 months of the year, then sit back and relax.
Although this debate is definitely an interesting one, the most important aspect is just simply making sure you’re in the market. If you have advanced to the stage where the argument between DCA and LS even comes up for you, then I at least know you’re a step ahead of the game because you are actually putting money into the market! So many don’t even put money into the market, so this debate is mute for them.
Thanks for sharing this breakdown!
Sean – you speak the truth my man! You are right, this is advanced stuff. First you need to get in the game and then talk tactics.
I totally agree that LS is a better strategy, on average, but I do worry that there is an asymmetry to the outcomes. Being up isn’t the same as being down (at least when the amount involved is big enough), and DCA does help mitigate in the worst-case scenarios. Great post and helpful reminder
Paul – what a good point! If you are less tolerant of losses than please with upside then is LS still better? Dunno – but that could be the topic of a new post! Thanks for stopping by!
I dollar-cost-average mostly by virtue I don’t have a lump sum. I have a feeling DCA would beat LS if you invested the LS at the end of the DCA period rather than the beginning.
I think it makes sense that DCA wins during periods of decline such as the depression or the 70’s – you’re betting that the market goes down, but you’re unsure of when.
I mean unsure of when it hits bottom and starts to go back up.
Yes you’re right DCA would beat LS if the LS was at the end of the period.
A very useful post. I updated my short analysis on DCA for the “Young Investor” at Mindfully Investing with reference and link to your post here. Previously, I had pretty much relied on the Vanguard study, but I’m glad you dug deeper and verified their conclusions. A very mindful analysis!
Karl – thanks for dropping by!
Thanks – I think this comment might have stuck in WordPress hell. Sorry about that!
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