Don't Dollar-Cost Average a Lump Sum

Recently a reader emailed me and said he had contributed the entire amount allowable to his IRA for 2008. He was wondering if he should invest it all at once or dollar-cost average it over some period of time. I said that most advisors would recommend investing the lump sum at once, and that's what I did as well.

CCN money agrees that investing a lump sum is better than dollar-cost averaging it. Here's what they recommend:

Settle on a blend of stock and bond funds that makes sense given your risk tolerance and investing time frame, and invest it in that mix all at once.

Here's their rationale:

If you believe in dollar-cost averaging, you would [invest] gradually. You might move $5,000 each month, investing $3,000 (or 60% of each monthly $5,000 chunk) in stock funds and $2,000 (40%) in bond funds. At the end of a year, your entire sixty grand would be invested in mutual funds. Over the course of the year, you would have actually been investing much more conservatively than you intended when you chose a 60-40 mix. The reason is that you’re holding on to so much cash, you’re virtually guaranteeing you won’t be at your 60-40 target mix for most of the year. By moving your money a little at a time, you’re actually undermining your investing strategy.

If, on the other hand, you do what I recommend - take your $60,000 and invest 60% in stock funds and 40% in bond funds (or whatever mix you choose) all at once - you’ll be invested exactly how you want to be from the very beginning. If you then do the same thing with any additional money you invest - and then rebalance your portfolio every year - you’ll maintain that same trade off between risk and reward.

His reasoning makes sense, but mine is a bit different. For me, it's all about time and trying to maximize my return. I could contribute to an IRA at the beginning of the year, sometime throughout the year, or the end of the year. Then, I could invest that money as soon as I wanted or wait forever. Here's what I do:

• I contribute the entire amount at the beginning of the year.
• I invest the entire amount immediately.

Why? Because this gets the power of compounding working for me immediately. If I waited part of a year, a whole year, or even longer (I could contribute the money but simply leave it in cash for years), I'd be forfeiting time when my money was growing, and that could significantly negatively impact my overall return. This is similar to what Consumerism Commentary's readers had to say on the issue.

Of course, the true better option can only be determined after the fact. So if you have a crystal ball, use it and invest accordingly. Otherwise, I'd go with the lump sum.

What do you think? Am I correct or off base?

Comments

[Kyle]

Lump sum investing will often result in higher returns over long periods of time, but not always. If the market drops significantly immediately after you buy in with your lump-sum, it will turn out that DCAing will have been the better long-term choice. If not, lump sum investing will have been the better choice. If it were me, I would decide between the two options based on market valuations. In 2000, I would have DCA'd since the market P/E was in the high 20's. If it were 2002, I would have lump-summed it since the P/E was far more reasonable. In today's market, I would lump-sum it. Some might call this market timing, but I think value-averaging is closer to correct. In practice, I would only choose to DCA in cases where the market was obviously over-valued, as was the case in 1999.

[moneyandpf]

I would like to make a point though that if someone does not have a large amount up front of cash to put into an investment that DCA still is a fine option. Setup an automatic transfer each month (Most will let you do this for amounts as little as $50/mth) if you are afraid you won't be able to save up the lump sum amount.

[Kurt]

You two are using the same reasoning. The "downside" of having too much cash in the article is the overly conservative asset allocation. This is the same concern you have.

Dollar cost averaging is a boneheaded idea. Investing asap is a better one. When you have recurring income (from a paycheck, for instance), the two are equivalent, and I think that's where people get confused. Don't save up to invest large sums. But don't withhold investing to invest small sums.

[Jake]

Simple argument:
(1) Invested money produces positive returns over time, on average.
(2) Although there are periods of negative returns, it is impossible to predict when those periods will occur with any certainty.
(3) It logically follows from #1 and #2 that the optimal strategy to maximize returns is to maximize the amount of money you have in the market and to maximize the amount of time your money spends in the market.

[JACK]

It was said above, but it bears repeating: for most people, investing the lump sum is dollar cost averaging. If you are setting aside some each month to invest, there's little point to further spread that out over time. Invest the money and let your continued investment be your method of getting "cost averaging".

If you need to save up before you can invest, I see nothing wrong with having the money going to a cash account until you have enough to purchase your investment if that helps you get there. But don't think that has anything to do with dollar cost averaging. Until you actually by shares of the stock or mutual fund, all you have done is move funds around. It may be helpful to your investment strategy, but it isn't dollar cost averaging.

[JACK]

Or in your example, FMF, let your annual contribution, over time, be your form of dollar cost averaging.

Most people probably aren't in a position to fund their IRA in full at the start of a year. So they are more clearly dollar cost averaging by default. But the bottom line should be: if you set it aside for investment, invest it.

[7million7years]

Hmmm ... I'm in this boat right now, and the biggest issue is the one that we are all told to ignore ... it's MARKET TIMING.

You need to decide FIRST if you are comfortable investing into an asset class right now, ONLY THEN should go ahead and invest as quickly as the opportunities allow.

Fortunately for me (a) I've been able to get legal/ethical/safe offshore bank interest of 7.5% on my lump sum/s and (b) it looks like the US buying opportunities are (almost) upon us!

[mysticaltyger]

I'd agree with investing the lump sum all at once. But I do think you have to be careful about putting it into something really aggressive. I think the best bet for most people would be some of the good balanced funds out there like T. Rowe Price Capial Appreciation, Fidelity Balanced, or Vanguard Wellington. All of these funds have beaten the returns of the S&P 500 over the last 10 years.

[Tim]

I believe in dollar cost averaging. However, I also believe in market timing . Although I don't recommend this to ANYONE. However, If you have successfully proven that you can time the market, then should you do it. I've been very successful with market timing beating the S&P 500 Index 6 out of the last 7 years. That being said, I would personally not dump the entire amount into the market but I would wait for a better entry point. I generally use technicals along with market sentiment as my entry indicators. Unfortunately, my exit points havn't been quite as successful as I the rallies usually last longer then I anticipate.

For someone with less experience, I would recommend to not put the entire lump sum in the market all at once. I would recommend splitting the money into at least 4 chunks and invest quarterly.

[Tim]

I want to clarify my last point. The reason I would recommend quarterly investing vs. lump some is mostly due to today's market envirement. If we were in a stong Bull market, I would opt for a lump sum.

The decision also has to be based on the investors personal risk tolarance and the years of investing experience. For example, I would not recommend a lump some for a first time investor no matter what the market conditions were.

[Wisepicker, personal finance]

All at once strategy is not only more effective in terms of yields, as you correctly expose, it's also easier to achieve. And the quantity to start with does not need to be that high as to start saving.

What would I suggest is to divide the investment budget to keep a fixed percentage devoted to old-time investments, and the rest hold to cash, ready for quick opportunities to be grasped along the way.

The ratio between these 2 types, I'm not sure, but in my case 2:1.

[Stephanie]

I guess I'd agree that for many of us, we invest, say, once a month because that's what we're able to do. I wish I had the sort of money they talk about ($60,000) to be able to invest. But since I don't, I'm able to put money into my retirment accounts every month, and it turns into a dollar cost averaging of sorts. And some people say that DCA is a gimmick...and so what if it is?! If your options are to either not invest at all (because you're too scared), or let the gimmick get you to invest a little at a time (so that you're not completely draining your accounts to purchase funds), then you're slowly working your way into the investing world!