Few savings strategies are more ingrained than dollar-cost averaging, where an individual invests a set amount at set intervals through thick and thin. This is essentially how your 401(k) works. Saving in this manner minimizes risk and keeps you on a steady path. Yet this time-tested formula isn’t necessarily for everyone.
Some math majors at mutual fund giant Vanguard poked a hornet’s nest earlier this month, when they advised that investors with a lump sum are better off putting their money in the market all at once. Financial planners everywhere instantly cried foul, and the dollar-cost averaging pioneers of the 1940s rolled over in their graves. Do you know what it feels like to inherit, say, $50,000 and sink it all in a stock index fund just ahead of a 20% decline?
Yet the math doesn’t lie. Vanguard basically found that the gut-wrenching scenario just described happens so seldom you should ignore it and plow forward.
Vanguard looked at two sums—$1 million and $20 million, representative of some extremely fortunate heirs. The math majors ran thousands of simulations over rolling 10-year periods since 1926. They looked at money invested all at once, and compared the returns against money invested over periods ranging from six months to three years. This was done for markets in the U.S., U.K. and Australia.
The chief finding: The longer one took to invest, the lower the total return. For example, those who invested the entire lump sum on day one outperformed those who took a year to get fully invested two-thirds of the time. A $1 million portfolio invested all at once in a mix of 60% stocks and 40% bonds turned into $2,450,264, on average, compared to $2,395,824 when invested over the course of a year—a difference of more than $54,000.
In many ways, the hoopla surrounding this finding was the biggest surprise of all. After all, the market has a tendency to rise over time. So those who invest the most the earliest should do the best most often. The superior long-term returns of lump sum investing have been acknowledged for more than 30 years.
Dollar-cost averaging works best in periods when markets experience wide swings but end about where they started—as was the case in the 1930s, which led scholars to the formula in the years that followed. This has also been the case for the past dozen years; a period marked by dips and rallies but in which the major stock market averages have gone nowhere.
In this kind of environment, investing a set amount of money each month ensures that you will buy more shares when they are low and fewer when they are high. You may even show a gain in a market that is flat or down a bit. But this edge does not exist in a market that rises, as is the most common experience.
Let’s not throw dollar-cost averaging to the wolves just yet, though. For one thing, it’s the only way most people can invest—by putting away small chunks of every paycheck. And human psychology is such that we find losses more aggravating than we find gains satisfying. So the piece of mind that comes from trickling a bonus or inheritance into the market over a year or two as opposed to going all in may be worth the almost certain underperformance.
Meanwhile, averages are only that. In a quarter of the simulations, dollar-cost averaging with $1 million beat the lump sum approach by $43,000 or more, and in 5% of the cases dollar-cost averaging beat lump sum investing by more than $200,000. Arguably, this risk reduction is worth the greater likelihood that you’ll forfeit gains—especially for older savers with just 10 to 15 years before retirement. Anyone under 45, however, should find the lump sum model compelling—so long as they are diversified and comfortable with their asset allocation.