The Pros and Cons of Lump Sum Investing versus Dollar Cost Averaging

DIY investors may face an important decision at certain points during their investment journey – what to do with a financial windfall, whether that’s a bonus, inheritance, a large SARS refund, or the sale of a company or asset.

Investing these funds into the stock market is a good way to increase the value of your capital over time, but it’s important to use the right strategy, not only regarding where you invest but also when and how.

Deploying capital

Dollar-cost averaging (DCA) and lump-sum investing are the two common strategies for investing money.

DCA entails investing a fixed amount of money in a particular asset at regular intervals, regardless of its price or the market conditions.

This approach can work for windfall amounts by splitting the contributions over multiple months. Investors can sustain this approach with smaller contributions beyond that from a regular source of income, like your salary or reinvesting dividends. 

A lump sum investment, on the other hand, allocates the full amount at once, rather than spreading contributions over time.

Which strategy is best?

When it comes to investing in more volatile assets like stocks or exchange-traded funds (ETFs), the DCA approach may offer some benefits over lump sum contributions.

Embracing the DCA strategy can help reduce the impact of market volatility and potentially lower the average purchase price of the asset over time, reducing timing risk. 

This strategy works because you typically buy more shares when the stock price is low and fewer shares when the price is high, all while investing the same amount each time.

By investing regularly, DCA mitigates the risk of trying to time the market, as you’re not trying to predict short-term price movements. Over time, the goal is to have a lower average purchase price per share than if you had only bought shares at or near their peak at one time.

However, there are various circumstances when deploying a lump sum can yield better returns.

For instance, lump-sum investing typically yields better long-term returns in bull markets because you maximise market exposure at a time when markets are rising.

A Morningstar study that explored how a 60/40 stock-bond split and an all-equity portfolio would have fared at specific periods in market history found that in roughly one-third of circumstances, DCA delivered better returns than lump-sum investing.

However, this outperformance mainly occurred in market downturns where falling prices brought down the average cost with each investment.

In contrast, lump-sum investing outperformed DCA about 75% of the time in long-term bull markets.

Data from a study conducted by Northwestern Mutual showed that investing a $1 million lump sum generated better cumulative total returns at the end of 10 years than DCA almost 75% of the time, whether that was 100% in equities or with the traditional 60/40 split.

Time in the market

Those who support lump-sum investing over DCA in all market conditions believe that time in the market will deliver better returns than timing the market. 

Interestingly, this market philosophy does not hold true in reverse – DCA becomes a better option than saving and accumulating cash, waiting for the right market conditions to invest.

To illustrate this point, a study by Vanguard analysts showed that taking a DCA approach to investing in the MSCI World Index over a four and half-decade period from 1976 to 2022 was better than remaining completely in cash, outperforming cash 69% of the time.

This mindset believes that the greatest advantages come from investing in markets sooner rather than later to maximise your time in the market.

DCA pros and cons

Pros:

1. Reduces timing risk: Spreads out investment over time, lowering the risk of investing all your money right before a market downturn.
2. Emotional discipline: Encourages consistent investing habits and reduces the emotional impact of market volatility.
3. Beneficial in volatile or declining markets: Can lower the average cost per share if prices drop during the investment period.
4. Accessible: Helps investors who don’t have a large lump sum to invest at once.

Cons:

1. Lower average long-term returns: Historically, markets trend upward. Spreading out investments may miss out on gains compared to investing earlier with a lump sum.
2. Opportunity cost: Uninvested cash may lose value to inflation or earn minimal returns.
3. Complexity: Requires ongoing monitoring and management versus a one-time decision.

Lump-Sum Investing pros and cons

Pros:

1. Higher expected returns: Statistically outperforms DCA about 75% of the time in long-term bull markets, due to immediate exposure to market growth.
2. Simplicity: A one-time investment requires less active management.
3. Full market participation: All capital is put to work right away, maximising time in the market to deliver compounding returns.

Cons:

1. Higher short-term risk: If the market drops shortly after investing, the entire sum is exposed.
2. Psychological barrier: Fear of a market downturn can discourage immediate investment.
3. Requires liquidity: Investors must have the full amount available upfront.

Making the decision

Investors who are focused on performance and have a high risk tolerance should consider investing a lump sum as soon as possible, regardless of market conditions or stock prices.

More risk-averse investors can use DCA to gain market exposure over time and achieve a smoother return profile, which is better than delaying an investment decision due to fears of losing value by investing a lump sum at the market peak.