Investing is largely a psychological process. It is part of human nature that the present moment often feels exceptionally uncertain. This is not made any easier if you are responsible for investing a highly significant amount of money in the stock market. Many investors wonder which is the better approach: lump-sum investing or dollar-cost averaging?
No one knows for certain which strategy will generate better returns over a time horizon of 10 years, for example. What we can do, however, is to study historical data to determine which of these strategies for investing in the stock market suits each investor.
The strategy chosen by the Sifter Fund is to be 100% invested in the stock market in all market conditions.
What do the studies say?
In 2012, Vanguard published a study titled ”Dollar-cost averaging just means taking risk later”. The study compared dollar-cost averaging (DCA) with lump-sum investing (LSI).
The study focused on historical performance across three markets: the United States, the United Kingdom and Australia. Vanguard divided the historical market data into rolling periods of 10 years, starting from 1926 and extending all the way to 2011.
Using these rolling time periods, the authors created over 1,000 scenarios and also compared different portfolio allocations between stocks and bonds, for example.
The scenarios for lump-sum investing were simple, with the entire amount invested at the beginning of each rolling period of 10 years.
For dollar-cost averaging, Vanguard studied multiple alternatives, with the DCA period ranging from six to 36 months.
The uninvested funds were held in cash until they were invested.
Lump-sum investing outperformed Dollar-cost averaging two-thirds of the time on average
For example, in the United States, with a portfolio consisting entirely of equities, the lump-sum investor outperformed the DCA investor 66% of the time. Conversely, DCA generated better returns for a 100% equity portfolio in the United States approximately 34% of the time.
The longer the DCA period, the more likely it was for the lump-sum investing strategy to come out on top.
Lump-sum investing was more profitable in all of the markets tested in the study and with different portfolio allocations between stocks and bonds.
The study included over 1,000 rolling periods of 10 years between 1926 and 2011. Based on this historical data, it can be inferred that lump-sum investing offers higher expected returns than dollar-cost averaging.
The results were also analyzed based on risk-adjusted data in various scenarios. Lump-sum investing was found to be more profitable, even with the risks taken into account, while dollar-cost averaging was found to be a much more conservative approach to investing in stocks.
In light of Vanguard’s research, it has been more profitable to invest funds in the market in one go and as early as possible instead of averaging out purchases over time.
Does Lump-sum investing suit everyone?
Maximizing returns is not the primary motivation for all investors. For some, preserving capital can be more important. This is understandable.
When the markets are trending down, dollar-cost averaging may perform better. Vanguard’s study found that, in lump-sum investing, the 10-year return was negative 22.4% of the time. In the dollar-cost averaging scenarios for the corresponding time periods, the return was negative only 17.6% of the time.
This shows that dollar-cost averaging has been a slightly more conservative and lower-risk approach to investing.
1. If the investor is primarily concerned with minimizing downside risk and avoiding potential feelings of regret (due to investing a lump sum just before a market downturn), dollar-cost averaging may be of use.
2. While the psychological concerns related to investing should not be underestimated, the DCA investor should weigh these concerns against (1) the lower expected returns of cash and bonds compared to stocks, and (2) the fact that delaying investment is itself a form of market timing, which few investors succeed at.
It should be noted that many investors do not have the option of investing a significant lump sum immediately. Instead, their only option is to invest a proportion of their monthly income in the stock market, for example.
In such circumstances, dollar-cost averaging is completely justified and, indeed, DCA investors have historically achieved fairly good returns on equities, sometimes even outperforming the lump-sum investor (33% of the time).
Historical data shows that investing in equities is key
According to Vanguard’s study, compared to dollar-cost averaging, lump-sum investing has been the more profitable approach to investing capital in the market most of the time.
While dollar-cost averaging has not necessarily been the most optimal strategy in light of the historical data, it is still significantly better than not investing at all.
The assets invested in the Sifter Fund are invested in the stocks of high-quality companies in all market conditions. While we are conscious of the volatility of the stock markets, experience has shown us that attempting to time the market often leads to weaker performance.
At Sifter, we reduce the risk for our investors by having a portfolio consisting of a small number of high-quality companies that we have carefully analyzed and keep a close eye on.
Riku Pennanen
Investor Relations, Sifter Capital
Investors must always decide for themselves whether they want to try to time the market, and what is their appropriate portfolio allocation between equities and other investments. It should be noted that the examples presented in this article are based on historical data. Future returns and scenarios cannot be entirely identical to the past and they may deviate significantly from historical performance. The different strategies mentioned in the article may prove to be better or worse than what the historical data suggests. The loss of the invested capital is also possible regardless of the strategy used.
