Does DCA provide better returns than a lump sum strategy?Contributors Jordan Jackson, Katherine Roy
This blog is the second in a two part series that explores how retirement plan participants and cautious investors can leverage dollar cost averaging, while also discussing the downsides when compared to a lump sum investing strategy. There is no shortage of pieces available that argue both sides of dollar cost averaging however, we believe it is critically important for retirement participants to systematically contribute a portion of their paycheck to their retirement, regardless of market conditions, to reach their desired outcomes. Though investors with cash on the sidelines are more likely to achieve better returns by putting their money into the market all at once, rather than dollar cost averaging.
Dollar cost averaging (DCA): Investing predetermined, fixed dollar amounts over a period of time.
Lump sum investing (LSI): Investing a sum of capital immediately upon receipt. Lump sums can come from several different sources—a pension payout, inheritance, the sale of property or a business.
In our previous post previous post we highlight the benefits of dollar cost averaging as a useful investment strategy for retirement participants and for investors worried about volatility in the near term. But for investors who’ve experienced a windfall of cash and are considering what to do with it, history suggests you’re better off putting your money into the market and letting it ride, rather than tip-toeing in.
It is typically during periods of uncertainty when the idea of DCA is emphasized to get people to move from cash to investments – and while this is better than continuing to stay in cash, it is addressing the behavioral issue, but is not generally the most optimal strategy. Using what we know from history, we can help clients overcome the anxiety tied to market volatility and get money invested.
Markets spend more time rising than falling. Even with periods of sideways markets, the ability for the index to grind higher has meant more reward to those using LSI over DCA. In fact, 66% of all monthly S&P 500 returns going back to 1990 have been positive1--allowing LSI to consistently outperform. As highlighted, if we compare DCA and LSI on a rolling one-, three- and five-year basis over the past 20 years, lump sum investing has outperformed dollar cost averaging over 70% of the time over each rolling period.
While DCA may remove the emotion from investing, not only has LSI been proven to consistently outperform, but investors should also consider that in the current low-interest rate regime, cash has a real negative yield, leaving them penalized for holding large amounts of cash while they dollar-cost average. Moreover, even though DCA has been shown to provide a buffer in downward trending markets, you have to start the strategy at the right time to reap its benefits.
In short, making decisions on what we know over what we’re scared of, has shown to provide better outcomes for investors. Therefore, for those investors looking for more predictable better investment returns over the long run, understand that volatility is normal and know that cash will not earn anything; lump sum investing is a superior investment strategy.
Consistency of outperformance using LSI
Percent of rolling periods LSI outperforms DCA