Lump Sum or DCA: What’s the Smarter Way to Invest?

Hi there! Is it already summer or am I the only one that is feeling the heat?

Hellooo…yes I can definitely see you sweating profusely! Even though it is relatively cooler up here with a steady breeze blowing, I can definitely say it has been warmer than I would like.

Thank you for affirming that because now I know it is just not me that is suffering! Even my mind working overtime to answer some questions is raising the temperatures in my head. I would really appreciate your inputs there too.

I can completely relate to the feeling of the mind racing full throttle and then trying to calm it down. Yes, we can definitely talk about what you are thinking. What is on your mind today?

I have been following the steps we discussed to invest my paycheck in the most efficient way and that has been working like a charm. [Check out this blog to learn on the best way to utilize your paycheck] I am at the step where I can afford to invest any extra cash that I am left with because I have completed all the previous steps. Now, I am expecting to get a bonus in the coming month and not sure what is the best method to invest it?

First of all, congratulations on earning a bonus and keep up the hard work! In these times any extra cash is gold both metaphorically and literally if you end up buying gold! I can see that you are faced with the dilemma of deciding between investing your entire bonus at once or maybe doing it in parts over a period of time. Here are the more technical terms for the options you are choosing between:

Lump sum investment – This is where you invest all your money at once in a particular asset.

Dollar cost averaging (DCA) – This where you break down your cash in smaller amounts and invest them at regular intervals of time, which could be weekly, monthly, quarterly, etc.

Did I understand your problem correctly?

You are spot on with the decision I am struggling with. I am surprised to know there are technical terms associated with the options I am thinking about. I can see pros and cons for both these options but it will be nice to hear your thoughts.

Of course! This is something a lot of people will have questions about, so you are definitely not alone there. The answer to which option is better is very subjective and is dependent on your risk tolerance. So like you said it will be worth thinking through the pros and cons of each option and hopefully that will make you realize which option works better for you.

Let’s start with Lump sum investment. Here you are basically going all in with your investment. The best scenario for this strategy to win will be if the markets have hit rock bottom and the only way for them to go is up. This means you can buy the investment at its lower price and expect to make the maximum returns by using all the available money to buy it. The biggest caveat to this strategy is knowing if the market is at the bottom, which nobody can tell with certainty. However, even if the markets are not at the bottom, this strategy wins over the DCA option about 66% of the time, irrespective of the asset allocation between stocks and bonds, based on a study conducted by Vanguard.  https://static.twentyoverten.com/5980d16bbfb1c93238ad9c24/rJpQmY8o7/Dollar-Cost-Averaging-Just-Means-Taking-Risk-Later-Vanguard.pdf 

In this study, they considered three different markets – US, UK and Australia and then invested 1 million amount either through Lump sum investment method or DCA method over different amounts of time. They also invested this money in different allocations between bonds and stocks. Next, they compared the account balance at the end of 10 years and they did this across different 10 year periods between 1926 to 2011. Acoss all these periods, the Lump sum investment method outperformed the DCA method about 66% of the time in all three markets. It is interesting to note that the average amount by which it outperformed is about 2%. Now, this suggests that mathematically speaking, lump sum investment is the way to go since it has a higher probability to outperform the DCA method. However, you have to realize that the degree by which it outperforms is not substantial depending on how much you value stability. This is because the number of times (22.4% vs 17.6%) and the amount ($84,001 vs $56,947) by which the portfolio from Lump sum investment went down was higher than DCA. So, if you are someone who is risk averse and is more concerned of protecting your downside then the advantage of 2% higher returns may not justify the additional risk.

There was a similar study done by Northwestern Mutual that compared Lump sum investment with DCA strategy and came to the same conclusion. They found that a 100% equity investment will outperform 75% of the time over 10 year periods. The reason they said this strategy is better is because investments other than cash have higher returns so any strategy which involves higher investment in instruments other than cash for longer periods will have higher returns, which is what lump sum investment does. Another reason they allocated the success of lump sum investment was that markets have historically gone higher over time for the majority of the time which favors getting into the market as early as possible to make the most of the rise in value.

Awesome, I am glad that there has been a detailed study to compare the two strategies by independent agencies. I understand that the lump sum investment strategy comes out on top in terms of returns over the same period of time but is also risky since during that time it can go through higher drop in value and that too more frequently. So, if I can handle the higher volatility and pay that price for higher returns then it would work for me. What do you think are some benefits of the DCA strategy?

I definitely see the DCA strategy as a way to ease your investment into the market. Sometimes you can feel overwhelmed when you have a large amount of money to invest and do not know if now is the best time to invest it. Because say you invest all your money today and the market crashes tomorrow, how bad would that make you feel and the regret you will have will stay with you for the rest of your life. This is why the 33% of the time that DCA works better in the studies above is during periods when the market is trending down. So, if you are too worried about losing money and trying to time the market by waiting for it to bottom, then in that scenario it is better to invest your money using the DCA strategy. This decision is better from a psychological and behavioral point of view than a financial point of view. However, you have to remember that the period over which you DCA is also important because the studies showed that if you DCA for more than 1 year then the returns compared to the lump sum strategy decrease even further. So, if you like the DCA from a lower volatility point of view then try to complete investing all your money within 1 year. 

One interesting thing to note is that you are already doing DCA with your 401k or other retirement accounts where the money is taken from your paycheck biweekly or monthly and invested into the portfolio you have selected. Here, you have no control over deciding between lump sum and DCA method but it is important to realize that you are already doing DCA in one of your investment accounts. It is for accounts like IRAs that you would have more control on when and how you invest your money. [Check out this blog to learn more about the different types of retirement accounts]

I also like the in-between strategy that The Money guy show came up with that finds a pretty neat balance between the DCA and lump sum strategy. They basically advise on how to invest your money based on how much amount that money is compared to your total liquid net worth. This is a way to decide if the money you are about to invest is a life changing amount or not. For example if you have $10,000 to invest and your net worth of investment is $1,000,000 then the amount you have to invest is 10% of total net worth. For this amount they recommend investing all the money as a lump sum investment. However, if you have $500,000 to invest i.e. 50% of your liquid net worth, then you DCA it over a 1 year period. This way the risk associated with a lump sum investment reduces for an amount of money that is significant to you. I personally like their guidance the best on how to make the best of both the strategies.

Wow! I never really thought there could be a mid-way to choose between these two options but I am glad to know that there is some guidance out there on how to do that. I really like the idea of first deciding if the amount of money you are investing is a lot for you or not. If it is not then the financial choice of lump sum investment is the best but if it is a lot then it makes sense to reduce the risk of losing value and use DCA. Thank you so much for going over the strategies with me because I can already feel my mind cooling down after finding the answers it was looking for. I will see you soon!