Investing Lump Sums: Is There an Optimal Strategy?
It is very likely that, at some point during an investor’s life, they will be faced with a difficult decision of when to invest a large sum of cash. There are two basic strategies investors may employ to invest their assets: invest the lump sum immediately (LSI), or buy into the market in several installments over time, commonly referred to as dollar-cost averaging (DCA).
A recent research paper by Vanguard, “Dollar-cost averaging just means taking risk later,” simulates rolling 10-year historical portfolio returns using both strategies to determine which produced the best results. Vanguard’s research suggests that LSI outperformed DCA strategies in two-thirds of the 10-year scenarios tested. An interesting finding of this study is that, although investors perceive DCA as a method of reducing short-term downside risk, investing the lump sum all at once provided investors with a higher risk-adjusted return on average over the 10-year investment horizon, implying a more efficient return.
The root explanation for these results lies in the differences in expected returns among cash, stocks and bonds. Financial markets operate in terms of risk and return (i.e., the riskier the investment, the higher the return investors should expect to receive over time). While stocks and bonds have historically rewarded investors for taking on risk and uncertainty, the lower risk associated with investments in cash and cash equivalents has understandably resulted in lower returns on investment. Applying these fundamental principles to the LSI strategy, one should expect LSI to outperform DCA simply because it is fully investing in risky assets in the financial markets from the start.
While Vanguard’s research demonstrates that LSI is a superior strategy on average, there are still valid arguments for the use of DCA. If markets do decline during the investment period, the benefits of a DCA strategy can be quite significant; not only will an overweight to cash shelter an investor’s portfolio from experiencing the full decline of the market, but it also provides the opportunity to buy in to the market at lower valuations, thus increasing the long-term potential of the portfolio.
Behavioral finance studies show that investors are often more concerned about experiencing near-term portfolio declines than they are about maximizing upside potential. DCA provides nervous investors an avenue to gradually move toward their long-term allocation while reducing the risk of investing a lump sum at a market peak. This strategy can be viewed as a compromise: it is unlikely to generate the highest possible return, but in exchange it protects the investor from the regret associated with fully investing a lump sum just ahead of a market decline.
Although the empirical evidence points to the conclusion that LSI is a superior strategy, market conditions and each investor’s level of risk aversion should be taken into consideration when deciding between using DCA and LSI. Investors who are more risk averse may actually achieve better results with a DCA approach, either by chance if markets decline or by instilling the confidence needed for them to adhere to their allocation for the long term.