Which approach provides superior results?
Dollar-cost averaging is a systematic method frequently utilized to invest your money into the investment marketplace. One of the best examples of this strategy at work is in 401k plans because employee participants make equal and ongoing investments through payroll deduction. Dollar-cost averaging takes the guess work out of trying to decide when the best time is to make an investment because you will inevitably invest in market peaks, as well as market corrections. The results over time using this approach have proven to be positive for investors.
But what about lump-sum investing? For example, if you should receive an inheritance or a lump-sum bonus payment, is it better to invest that immediately or dollar-cost average the investment over time? This is one of the most common questions I’m asked and, fortunately, Vanguard Research performed a study in July 2012 that sheds light on which is the superior approach.
The Vanguard Research Paper, July 2012
In the Vanguard white paper, they compared the historical performance of dollar-cost averaging (DCA) with lump-sum investing (LSI) across three markets: the United States, the United Kingdom, and Australia. On average, Vanguard found that an LSI approach outperformed a DCA approach approximately two-thirds of the time, even when results are adjusted for the higher volatility of a stock/bond portfolio versus cash investments.
This finding was consistent with the fact that the returns of stocks and bonds exceeded that of cash over the study period in each of these markets. Vanguard concluded that if an investor expects such trends to continue, is satisfied with his or her target asset allocation, and is comfortable with the risk/return characteristics of each strategy, then the prudent action is investment of the lump sum immediately to gain exposure to the markets as soon as possible.
But if the investor is primarily concerned with minimizing downside risk and potential feelings of regret (results from lump-sum investment immediately before a market downturn), then DCA may be of use. Of course, any emotionally based concerns should be weighed carefully against both (1) the lower expected long-run returns of cash compared with stock and bonds, and (2) the fact that delaying investment is itself a form of market-timing, something few investors succeed at.
Bottom line applications
- Dollar-cost averaging is a proven effective method to invest in world markets regardless of what the investment climate may be – bull or bear
- The Vanguard study concludes that utilizing an LSI approach vs. a DCA approach improves an investor’s long-term return two-thirds of the time
- The conclusions of the study were consistent over both a 36-month and a rolling 10-year period.
- Feelings of regret and loss are valid emotional considerations and despite the evidence that LSI may produce superior longterm results, the emotional component may trump the logical component.
If you have any questions or would like a copy of the Vanguard Study, please don’t hesitate to contact me.
By Mark A. Chandik, President/Chief Investment Officer, FDP Wealth Management