Dollar cost averaging vs. lump sum investing

After devising an asset allocation plan, many investors wonder if it is wiser to immediately pour all of their assets (which are most likely sitting in cash) into the funds within their plan (lump sum) or to split the investments across several months (dollar cost averaging).  So, what method makes more sense for the majority of investors?

Simply put, if your goal is to maximize returns over the long-term, lump sum (LS) is the better course of action than dollar cost averaging (DCA) as it always has a higher expected return.

University of Chicago professor, Geoge Constantinides, supports this theory using complex mathematical and economics models in his paper, "A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy," which can be found here.  To break it down to the most simplistic premise, this conclusion makes perfect sense as it should seem obvious to any rationale observer that LS provides a higher likelihood of greater return than DCA because the market typically increases over time.  That is, since one expects the market to have a positive return, getting in it sooner rather than later is always the best bet.  Stated in another way, since the expected return of stocks and bonds is higher than that of money market funds and savings account, moving your assets immediately from asset classes with lower expected returns to higher ones will always increase your expected returns.  However, there is certainly no guarantee that this will play out in all situations and your actual returns may vary.  Thus, there is an important psychology at play when investors choose between using LS or DCA.  Another study concluded that LS beats DCA about 65% of the time - this number is not surprising since the stock market increases about 65% of the time.

Another argument for LS investing is that if you have set up an asset allocation plan of stocks/bonds that matches your risk profile and time horizon, why not follow it immediately?  If you decide that a 70% stock/30% bond mix is best for you and currently have $50,000 sitting in a savings/checking account, many would argue that you should implement the plan right away as it matches your directives.  Why would you want a 20% stock/10% bond/70% cash allocation for a quarter of the year (assuming you're DCA four times over the course of a year)?  If 70/30 makes sense for you in the long-term, then it makes sense now.  If you can't stomach the up's and down's that portfolio can sustain, then perhaps it's not appropriate for you.  These points certainly have merit and from a mathematical and statistic standpoint, LS is the way to go.

Having provided ample documentation that LS investing provides the higher expected performance over the long-term, I still don't want to make a blanket statement that everybody should utilize the LS strategy; and that is because of psychological factors and risk.  If you are a new investor that seeks to enter the stock market, but are a bit timid about the prospects of such a volatile asset class, then I think DCA is a good method.  Additionally, spreading out your investments over time certainly does reduce risk (although with a lower expected return).  There is no way to time the market and it is expected to increase in value over time, but spreading your investments into an index fund over the course of a year or so might make sense if it allows you to "stay the course" (i.e. not deviate from your designed portfolio asset allocation) over your lifetime.  As Warren Buffett has said, "My best holding period is forever."  DCA provides a method in which to spread out risk in case we have another year like 2008 even if it does have expected lower returns.  This rationale is certainly not without merit (sorry for the double negative) and for certain investors, DCA makes sense.

Note that even if you invest in a lump sum right now, you will still most likely be dollar cost averaging over the course of your lifetime as new funds become available.  I like to rebalance by buying additional shares of my existing funds, rather then selling my underperforming asset classes (unless, of course, I am tax loss harvesting, in which case selling negatively performing asset classes is the way to go).

To wrap up, lump sum investing provides the higher expected return over dollar cost averaging.  From a mathematical and probability standpoint, it is definitely the better method.  However, there are psychological factors at play in many circumstances and certain individuals may find comfort in spreading out their risk over the course of a year or so, and thus will find the dollar cost averaging method more suitable for their goals since it reduces their risk of picking the exact wrong time to jump in the market.  In the end, it won't make a huge difference over the course of a long-term investing lifetime.  Getting a suitable plan in place and implementing it is far more important than the rate at which you will be transferring your assets from cash to stocks and bonds.
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