One of the oldest tricks in the investment book is dollar-cost averaging (DCA). This technique suggests that investors will do well over time by slowly investing fixed sums of money into the markets at regular periods. By doing so they will take advantage of the low buying points while not putting too much money in at any one market top. This is how many employees end up investing through their employers’ savings plans – a specific percentage is deducted from each of their paychecks and invested into their accounts. Although many investors have been taught to invest this way over the years, its value is now being questioned by research conducted by the Vanguard Group, which runs the nation’s second largest mutual fund company.
Vanguard says its simulations of lump-sum vs. dollar-cost averaging in the U.S., British, and Australian stock markets since 1926 give the edge to lump-sum investing. It looked at two cases: one in which an individual received a $1 million inheritance and another where a charitable foundation received a $20 million cash gift. Vanguard said that on average investing the lump sums immediately would have resulted in bigger portfolios two-thirds of the time. This seems to work because stock and bond markets rise on more days than they fall, it said. “We conclude that if an investor expects such trends to continue, is satisfied with his or her target asset allocation… the prudent action is investing the lump sum immediately to gain exposure to the markets as soon as possible,” the study’s authors wrote. The study compared two methods of investing. In one, the lump sum is immediately invested into a portfolio of stocks and bonds. In the second, the money is invested in equal increments monthly over periods ranging from six months to 36 months.
When each portfolio’s results over the next 10 years were compared, the lump-sum approach often did better, Vanguard says. Why did this occur? Vanguard said it seems to be because when dollar-cost averaging a lump sum into the markets, the temporarily non-invested portion is held in cash accounts. Over time stocks and bonds have beaten cash accounts, so holding money out of the market for a period results in lower portfolio returns. Vanguard noted that these results do not invalidate dollar-cost averaging within an employer savings plan. In that case the other alternative would be accumulating the small regular contributions to the plan into cash, and then at some point timing the market and investing it all. “When investing through a retirement plan… investable cash becomes available only in relatively small amounts over time, which makes DCA a prudent way to invest,” Vanguard says.
However, it should be remembered that lump-sum investing works best when the investor can maintain an emotional balance for an extended period. If the investment of a lump sum would entail regrets if it was followed by an immediate market decline, and that regret would make an investor discard his original plan, then it might be safer to dollar-cost average the money into the market in order to keep the investor comfortable with staying the course.