What happens if you invest a large lump sum on a bad day—like the day before a big market drop? You might have to watch your freshly invested money start to wither away immediately. Proponents of dollar-cost averaging (DCA) argue their method is a way to avoid such a frustrating scenario. DCA involves dividing your money into smaller portions and investing gradually over time. That way, you can theoretically avoid the danger of investing all of your money on a particularly bad investing day. However, although DCA can spread out your cost basis over time, and can reduce the risk of investing everything on a “bad” day, investing a lump sum immediately is usually the more effective route for your portfolio in our view.
In some cases, portioning out smaller investment amounts can make sense. For example, 401(k) investors likely dollar-cost average their contributions inadvertently, simply due to the way most 401(k) plans are set up. Most individuals don’t have enough cash flow to max out their 401(k) contributions in one lump sum. Additionally, the Internal Revenue Service limits how much you contribute in one calendar year. Most 401(k) investors spread out their contributions in smaller sums over the year. Beyond 401(k)s, some investors may not have one lump sum to invest, and instead invest smaller amounts over time as they are able to. However, if you have a large lump sum that can be invested immediately, we believe you should take a look at how DCA could actually affect your portfolio.
DCA can cycle in and out of favor. Investors may be especially fearful of putting a large sum of money in the market during or after market corrections or bear markets. During such downturns or volatility, DCA could theoretically help investors by letting them take advantage of being partially invested in the market if an upswing happens, but also have cash on hand to buy at a lower price if the market continues to drop. Seems to make sense, right? But what happens if you use DCA during a positive year, especially one that doesn’t have big drops? You miss out on some potentially big upside. And missing out on positive market returns can compound over time.
Unfortunately, no one can perfectly predict future market movement, and past returns do not predict future returns. Since you can’t perfectly predict future returns, most of the time investors benefit from being invested more of the time than trying to avoid downward volatility. Said another way, time in the market matters more than timing the market. Consider that from January 1, 1998 to July 1, 2019, the S&P 500’s annualized return was 10.5%. [i] However, if you missed just the 10 best trading days out of those 8,216 trading days, the annualized return dropped to 8.1%. [ii] And if you missed the 30 best trading days? The annualized return drops to 5.1%. [iii] Lastly, what happens to that annualized return if you missed the 50 best trading days during that 8,216 trading day period? Down to 2.6%. [iv] Now, with DCA, theoretically part of your portfolio would be invested during that time. But even if just part of your portfolio was not in the market during those best days, you’ve missed out on some important returns.
Still unconvinced? Consider a study published in 1994 by Michael Rozeff. This study compared the results of dollar-cost averaging stock purchased over 12 months to a lump-sum investment each year. The results? Two-thirds of the time, the lump-sum method returned more than DCA. [v]
So if you are considering DCA, ask yourself: can you predict which years or time periods DCA will actually be more successful than lump-sum investing? Likely not. For investors who can’t perfectly predict markets (likely everyone), lump-sum investing is simply more likely to yield better results over time in our view.
What can average investors do if the fear of investing on a bad day still dominates their psyche? Remember that emotions can influence your investing—and often not in a good way. Many investors fear losses—usually even more than they appreciate gains! And the pain of regret can feel terrible, to the point that some investors may pursue a strategy with worse average long-term performance just to avoid the possibility of regret. If you find yourself falling prey to these fears, remember: Time in the market is more important than timing the market. The S&P 500’s annualized return from 1925 through 2018 is approximately 10%—which includes all of the downturns and volatility along the way. [vi] Waiting on the sidelines during a bull market can mean missing out on significant growth. Enduring market volatility isn’t easy, but dollar-cost averaging likely isn’t the answer.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
[i] Source: FactSet, Inc.; as of 07/02/2019. Daily S&P 500 Total Return Index, 01/01/1988 – 07/01/2019.Source: FactSet, Inc.; as of 07/02/2019. Daily S&P 500 Total Return Index, 01/01/1988 – 07/01/2019.
[v] Source: Michael S. Rozeff, “Lump-Sum Investing Versus Dollar-Averaging,” Journal of Portfolio Management (Winter 1994), pp. 45-50.
[vi] Source: Global Financial Data, Inc., as of 1/9/2019. S&P 500 Total Return Index, 12/31/1925 – 12/31/2018.
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