Jump or Ease In? Lump Sum Versus Dollar Cost Averaging

The Water is Fine

The Autumnal Equinox, aka the first day of Fall, was last week on September 22. You may not have noticed, as the high for the day was 94° F here in ATX. Yesterday, though, we woke to the first day in over six months that the thermometer read below 60°. This became VERY apparent when I stuck my toes in the water prior to my morning swim at our neighborhood pool.

Even though most will agree that jumping in and getting the initial shock over with is typically the best way to acclimate to cool water, it can be difficult to convince our minds that a more cautious approach isn’t more prudent after getting cold feet.

Frequently this dilemma also presents itself with investing. The question of whether to “jump in” the market and invest immediately versus employing a more gradual approach such as dollar cost averaging regularly comes up in my conversations with clients that have cash to invest. So what is the best approach?

12 time Olympic medalist, Natalie Coughlin, was once quoted as saying, "I actually love swimming but I just hate jumping in the water." If even the most successful pros face the same mental challenges as the rest of us, maybe the question isn't which approach is best. Rather, what does it take to get you in the pool?

First, let’s not confuse the question of what to do with a lump-sum versus accumulating wealth over time. If you don’t have a lot of money to invest and want to start by taking small amounts from your income (such as in an employer retirement plan like a 401(k)) and investing over time, by all means, do that. It is an effective way to grow your nest egg.

But if you have already saved up a pile of cash or had a liquidity event and want to invest for the long haul, decades of research[i] suggest that investing it all at once, or lump-sum investing, tilts the odds in your favor around 66% of the time. Nonetheless, that 66% is a lot like 66° water for a lot of folks. Some have the fortitude to jump right in, others need to convince themselves through a more cautious approach.

Stocks and bonds have expected returns that are higher than cash, so it stands to reason that the odds favor them to outperform over time. Another way to think about it is that for 2 out 3 investors, increasing stock and bond prices will just lead to higher average prices paid through dollar cost averaging (See exhibit 1). However, volatility is the trade-off for those higher expected returns.

 Exhibit 1: For 2 out 3 investors, dollar cost averaging will increase the average price paid as stock and bond prices tend to go up over time.

Exhibit 1: For 2 out 3 investors, dollar cost averaging will increase the average price paid as stock and bond prices tend to go up over time.

If the prospect of being on the short end of the stick about a third of the time is just too uncomfortable of a thought for you to jump right in, then dollar cost averaging may be the way to go. Besides, just as you can always dunk your head in the water to get it over with, you can accelerate your investment schedule if you acclimate sooner than you expected.

Either approach is better than staying in bed while your muscles wither from inactivity or purchasing power is diminished by inflation.  Time for a swim?


 

 

[i] Abeysekera, Sarath P., and E.S. Rosenbloom. 2000. “A Simulation Model for Deciding between Lump-Sum and Dollar-Cost Averaging.” Journal of Financial Planning 13 (6): 86–96.

Atra, Robert J., and Thomas L. Mann. 2001. “Dollar-Cost Averaging and Seasonality: Some International Evidence.” Journal of Financial Planning 14 (7): 98–103.

Brennan, Michael J., Feifei Li, and Walter N. Torous. 2005. “Dollar-Cost Averaging.” Review of Finance 9 (4): 509–535.

Constantinides, George M. 1979. “A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy.” Journal of Financial and Quantitative Analysis 14 (2): 443–450.

Dichtl, Hubert, and Wolfgang Drobetz. 2011. “Dollar-Cost Averaging and Prospect Theory Investors: An Explanation for a Popular Investment Strategy.” Journal of Behavioral Finance12 (3): 41–52.

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Greenhut, John G. 2006. “Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work.” Journal of Financial Planning 19 (10): 76–83.

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Milevsky, Moshe A., and Steven E. Posner. 2003. “A Continuous-Time Re-examination of the Inefficiency of Dollar-Cost Averaging.” International Journal of Theoretical and Applied Finance 6 (2): 173–194.

Rozeff, Michael S. 1994. “Lump-Sum Investing versus Dollar-Averaging.” Journal of Portfolio Management 20 (2): 45–50.

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