Sometimes people who are investing for their retirement receive a large one-time sum of money. It could be an inheritance, a company bonus or even some large lottery winnings. Let's just assume that a person who receives such a sum of money wants to invest it into his or her retirement.
There are basically two different strategies:
Which strategy would be the way to go?
For this simulation, I used historical data of the S&P 500 (SPY) as found on Yahoo Finance. I took the monthly level of the S&P 500 from 1970 to 2018 to look at the effect of lump sum investment versus dollar-cost averaging for specific periods of time. I looked five different time periods:
I used every quarter of a year as a possible starting point, and from that I obtained a huge amount of data. When comparing these types of strategies with one another, the following averages, maximums and minimums are found:
Average | Max | Min | |
Lump Sum (1Y) | 9.39% | 51.80% | -40.09% |
DCA (1Y) | 5.87% | 32.72% | -32.52% |
Lump Sum (2Y) | 18.58% | 75.12% | -42.58% |
DCA (2Y) | 10.51% | 44.34% | -38.36% |
Lump Sum (3Y) | 28.41% | 116.00% | -38.64% |
DCA (3Y) | 15.21% | 62.77% | -37.89% |
Lump Sum (4Y) | 39.36% | 172.02% | -33.13% |
DCA (4Y) | 20.21% | 79.60% | -36.13% |
Lump Sum (5Y) | 51.17% | 197.56% | -26.99% |
DCA (5Y) | 25.52% | 95.95% | -34.12% |
From these data, we can already draw a couple of conclusions:
Visually, these data can be depicted like this:
Source: My own calculations using historical data of the S&P 500
What you can see in the graphs: I filtered all the results of a specific time period from lowest to highest and then generated graphs of these data. Every small part of the x-axis is a single entry of data. Results from lump sum investment are colored blue, while dollar-cost averaging is orange. When the blue line is above the orange line (for positive results) or under the orange line (for negative results), it means that lump sum investment leads to more extreme results than dollar-cost averaging. This is almost always the case.
We can see from these graphs that the results of lump sum investment get progressively better on longer time periods. For dollar-cost averaging, the 1-year period clearly shows a lower downside and a lower upside when compared with the lump sum alternative. When looking at longer time period, the difference in downside becomes smaller and smaller, while the difference in upside increases. On the 5-year graph, the downside of dollar-cost averaging is even larger than the possible downside of a one-time investment: the blue line of lump sum investment is not visible anymore for most negative values, meaning that dollar-cost averaging led to worse results than lump sum investment.
One thing which I did not take into account is the interest which investors would receive on the not-yet-invested part of the money when dollar-cost averaging. With high interest rates, this can be an important factor. But currently, the effect of interest on this comparison is relatively limited.
To conclude, I would say that the question of dollar-cost averaging versus lump sum investment comes down to two things: the time period you want to continue dollar-cost averaging, and your market expectations for the long term. In the sample I used, dollar-cost averaging for up to three years insulates your portfolio from some risks and limits its upside. On time periods longer than about three years, lump sum investment is always better in this data sample.
It is very important to state the relevance of the data sample used for this calculation. I used the data of the S&P 500 from 1970 to 2018. Though there have been ups and downs during this time period, the index went from 850 to more than 2800 points. If I would perform this analysis on stocks or indices which were more or less flat during the measured time period, dollar-cost averaging would perform much better.
So the question of whether to dollar-cost average or not is also very dependent on your future expectations of the stock or index you're investing in. If you are skeptical about the future, dollar-cost averaging could still be the way to go. But do realize that this strategy always underperforms a one-time investment if markets keep rising on the long term.
Thank you for reading! If you have an opinion about dollar-cost averaging versus lump sum investment, please let me know in the comment section below!
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.