Here’s why lump-sum investing is a better option than dollar-cost averaging
Having a big wad of cash to invest means not only deciding what to buy, but when.
If you’re debating between investing the money all at once or through regular deployments at set intervals (known as dollar-cost averaging), be aware that you’re more likely to end up with a higher balance down the road by making a lump-sum investment, a study from Northwestern Mutual Wealth Management shows.
That outperformance holds true regardless of the mix of stocks and bonds you invest in.
“If you look at the probability that you’ll end up with a higher cumulative value, the study shows it’s overwhelmingly when you use a lump-sum investment [approach] versus dollar-cost averaging,” said Matt Stucky, senior portfolio manager of equities at Northwestern Mutual Wealth Management.
The study looked at rolling 10-year returns on $1 million starting in 1950, comparing results between an immediate lump sum investment and dollar-cost averaging (which, in the study, assumes that $1 million is invested evenly over 12 months and then held for the remaining nine years).
Assuming a 100% stock portfolio, the return on lump-sum investing outperformed dollar-cost averaging 75% of the time, the study shows. For a portfolio composed of 60% stocks and 40% bonds, the outperformance rate was 80%. And a 100% fixed-income portfolio outperformed dollar-cost averaging 90% of the time.
The average outperformance of lump-sum investing for the all-equity portfolio was 15.23%. For a 60-40 allocation, it was 10.68%, and for 100% fixed income, 4.3%.
Even when markets are hitting new highs — which is the current theme with the major indexes — the data suggests that a better outcome down the road still means putting your money to work all at once, Stucky said. And, compared with investing the lump sum, choosing dollar-cost averaging instead can resemble market timing no matter how the markets are performing.
“There are a lot of other periods in history when the market has felt high,” Stucky said. “But market-timing is a very challenging strategy to implement successfully, whether by retail investors or professional investors.”
However, he said, dollar-cost averaging is not a bad strategy — generally speaking, 401(k) plan account holders are doing just that through their paycheck contributions throughout the year.
Additionally, before putting all your money in, say, stocks, all at once, you may want to be familiar with your risk tolerance. That’s basically a combination of how well you can sleep at night during periods of market volatility and how long until you need the money. Your portfolio construction — i.e., its mix of stocks and bonds — should reflect that risk tolerance, regardless of when you put your money to work.
“From our perspective, we’re looking at 10-year time horizons in the study … and market volatility during that time is going to be a constant, especially with a 100% equity portfolio,” Stucky said. “It’s better if we have expectations going into a strategy than afterwards discover our risk tolerance is very different.”