Dollar Cost Averaging vs. Lump Sum Investing

Summary

In this video, Ben Felix, a Portfolio Manager at PWL Capital, compares lump sum investing and dollar cost averaging (DCA). He explains that while DCA feels intuitive and helps minimize regret by investing over time, research shows lump sum investing generally outperforms it. Even though DCA can be psychologically comforting, it incurs higher costs and often yields lower returns. Felix suggests that lump sum investing is usually optimal, especially when investors are ready to make decisions based on an appropriate risk profile. However, if behavioral biases cause hesitation, adjusting asset allocation might be a better solution.

Takeaways

• 😀 Dollar cost averaging (DCA) involves systematically investing equal parts of a lump sum over a period, but it is generally suboptimal compared to lump sum investing.
• 😀 Lump sum investing has been proven to outperform dollar cost averaging 65% of the time over long periods, with an annualized cost of 0.38% over 10 years.
• 😀 DCA's primary appeal is behavioral, helping investors minimize regret by avoiding the risk of investing right before a market crash.
• 😀 While DCA can offer a slight advantage during the worst 10% of market outcomes, it still trails lump sum investing more than 50% of the time, even in those scenarios.
• 😀 Even in a market downturn, such as after a 20% or greater drop, lump sum investing still performs better on average than DCA.
• 😀 Historical data and academic research consistently show that lump sum investing outperforms DCA in a rational decision-making framework, even in volatile markets.
• 😀 Behavioral biases, such as the fear of regret, often drive people to favor dollar cost averaging, even though it leads to lower returns.
• 😀 If an investor is highly concerned about regret, they may benefit from reconsidering their asset allocation rather than relying on DCA as a solution.
• 😀 Waiting for a market dip (10% or 20% decline) before investing generally underperforms lump sum investing over most 10-year periods, even if the market is at an all-time high.
• 😀 Investors should aim to invest their lump sum into a risk-appropriate portfolio as soon as possible for optimal returns, unless behavioral factors strongly suggest otherwise.

Q & A

What are the three options available for investing a lump sum of cash?

The three options are: 1) Invest the lump sum immediately in a risk-appropriate portfolio, 2) Use dollar cost averaging, systematically investing equal parts into a portfolio over time, or 3) Wait until it feels like a good time to invest.

Why does cash feel safe to investors, and why does the stock market feel scary?

Cash feels safe because it's stable and does not fluctuate in value, while the stock market often seems uncertain due to factors like market valuations, world events, or economic news, which can make it appear risky.

What is dollar cost averaging, and how does it work?

Dollar cost averaging is a strategy where an investor systematically invests equal amounts of money into a portfolio over a set period, regardless of the market conditions. This helps to avoid investing a lump sum at a potentially high point in the market.

Why is dollar cost averaging often considered suboptimal compared to lump sum investing?

Dollar cost averaging is often considered suboptimal because, historically, investing a lump sum typically leads to better outcomes over time. Mathematically, lump sum investing has outperformed dollar cost averaging about 65% of the time in various market conditions.

What is the behavioral argument for using dollar cost averaging?

The behavioral argument for dollar cost averaging is that it can minimize regret by preventing an investor from investing a lump sum right before a market crash. It helps reduce the psychological discomfort of market volatility.

How does dollar cost averaging compare to lump sum investing in the worst 10% of outcomes?

In the worst 10% of outcomes, dollar cost averaging does have a small advantage on average, but it still trails lump sum investing more than 50% of the time, even when hindsight is perfect.

What happens if an investor tries to time the market by waiting for a drop before investing?

Waiting for a market decline to invest, known as 'buying the dip,' typically underperforms on average and often results in missing out on higher returns, even when waiting for a 10% or 20% drop.

Does dollar cost averaging help investors avoid investing right after a market drop?

Although dollar cost averaging can help avoid investing all at once during a market drop, it still doesn’t consistently provide better results compared to lump sum investing, even when the market has already dropped significantly.

Why might an investor be better off investing a lump sum instead of using dollar cost averaging?

An investor may be better off investing a lump sum if they are willing to accept the risks of market volatility because, in the long run, lump sum investing tends to outperform dollar cost averaging due to compounding returns.

What is a potential downside of using dollar cost averaging in terms of asset allocation?

Dollar cost averaging can be considered suboptimal if the portfolio being invested in is too aggressive for the investor’s risk tolerance. It may result in investing in risky assets in an unbalanced way, which could expose the investor to higher risks than they are comfortable with.