Do you prefer to drip-feed your investments into the market rather than invest in one single “big-bang”? Part 1 compared Lump Sum (LS) and Dollar Cost Averaging (DCA) strategies. If you haven’t read it and you don’t want a spoiler then look away now – the LS strategy wins hands-down! In most past scenarios a LS strategy will result in a larger ending value than adopting a DCA strategy. This is also what Vanguard found in a paper they wrote on the subject.
Before going any further you need to read the important notes.
Dollar Cost Average Investing
In part 1 we looked at how often the LS strategy beat the DCA strategy, and in this part we will look at the magnitude of the outperformance.
We saw the following results from part 1 where we plotted the outperformance of the LS strategy by starting year for a ten year horizon. This compares a LS strategy of a single investment on day one, with spreading the investment out over the next ten years. You can see that most of the periods (in fact 88% of them) resulted in the LS strategy winning. There were a couple of big exceptions like the Great Depression and the period of Stagflation in the 1970’s that we examined in part 1.
The average out performance of the LS strategy over a ten year period was in fact 2.6%, but you can see that there were a number of historical periods with outperformance way in excess of that. In other words it has paid to be invested in the market, and that’s why I don’t have an emergency fund in cash and don’t keep any “dry powder”.
But what happens when we reduce the period of investment to five years?
Changing the Investment Period
You can see it follows the same sort of pattern but more exaggerated highs and lows, and there are more periods where the LS strategy actually under-performed the DCA strategy. For a five year period the LS strategy won 78% of the time and the outperformance reduced to 2.4%.
So reducing the time period makes the LS strategy slightly less effective, but let’s be honest it’s still far superior to the DCA strategy in the majority of cases.
Now let’s lengthen the investment period to 30 years.
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Long Investment Periods
If we now consider a 30 year investment period we get some interesting results. The following chart overlays the 30 year period on top of the five year and ten year periods.
The black line shows the outperformance of the LS strategy over a 30 year period. It outperforms the DCA strategy in 100% (yes 100%!) of scenarios, and the average outperformance was 2.3%.
It’s also a fascinating chart in that we can see that the outperformance is clearly mean reverting. It’s converging on a sort of long term average. When I reflect on these blog posts I think they actually have nothing to do with the efficacy of a LS strategy versus a DCA strategy, but instead they are a homage to the amazingly robust mean reversion of real equity returns over two centuries!
Another feature that changes is the highs and lows get less “spiky” as we increase the investment horizon. This is simply due to the fact that we are averaging over a much longer period and so any one, or two bad years of investment performance can’t have too large an impact. Even major market upheavals like the Great Depression and 70’s Stagflation are no match for decades of cumulative investment performance.
This is pretty interesting, but we need to put it together into a coherent format.
Putting It All Together
I looked at all periods of investment from two to 30 years using the market data from 1802 onwards. In the last post we looked at how successful the LS strategy was and now we are going to quantify that success with the average outperformance.
The chart above shows the average outperformance of the LS strategy for different projection periods; it has a pretty pleasing shape doesn’t it? The clear takeaway is that whatever the asset allocation and time period the LS strategy results in a healthy outperformance against the DCA strategy.
You can see how my results diverge from Vanguard’s result and this reflects the fact that under short time periods of a year or two there is a much greater sensitivity to the idiosyncrasies of short periods of returns that get averaged away when you extend the projection period.
So over the last couple of posts we’ve looked at the benefits of investing a lump sum rather than dollar cost averaging. It’s hard to overcome the cognitive bias of fearing an immediate loss in capital from an event like the Great Financial Crisis, but these are extremely rare and the equity markets have shown extraordinary boucebackability (technical actuary term) over the last two centuries.
What d’ya think? Are you all-in on the lump sum strategy or still nervous about the markets and want to dollar cost average your investment? I can understand it, but the weight of analysis is compelling. If you believe in long term real equity returns then you need to get invested now. Oh yeah, also get that emergency cash fund invested too!
We can’t blindly accept these results without considering whether they are reasonable. Is there some quick quality-control we can use to check the veracity of these claims?
A simplistic model would be to look at a portfolio of 100% equities. Over any particular projection period the DCA strategy is a bit like investing the total amount at the half-way point. In reality, we have invested under half of our total sum in the first half of the period and then invested over half in the latter half of the projection period. But on average it is roughly like investing everything in at the halfway point. So the DCA strategy is a bit like a LS strategy for only half the time.
If we assume that equities have a real return of 5%, then half the return is 2.5%. I would therefore assume that the LS outperformance to be of the order of 2.5% per year, and if you look at the chart above – it is! Hurrah! And the Vanguard result was 2.6%. So I’m pretty confident that this is all hanging together