Dollar Cost Averaging or Lump Sum Investing: Which is Better?

This is actually a fairly common question that I get asked regarding my philosophy as well as my own investing habits. And I'm always kind of surprised that I haven't addressed it yet in a post. So this is me rectifying that omission! And what we are talking about here is dollar cost averaging versus lump sum investing. Which option is better? Or does it even matter at all?

Let's dig in!

Dollar cost averaging versus lump sum investing

Let's begin with some definitions via an example.

Let's say that you have $10,000 that you plan to invest in the stock market. There are a couple of different ways that you can do this.

You could take all $10,000 and invest it into the market according to your chosen asset allocation, or
You could take smaller amounts, let's say $2,000, and invest this smaller amount into the market every month for 5 months

The former is called lump sum investing. And the latter is dollar cost averaging.

Now, keep in mind that dollar cost averaging refers to any piecemeal investing based on a regular interval. So, in the example above, you could invest $5,000 every 6 months for 1 year or $1,000 every month for 10 months or so on and so on. The actual dollar amounts being divvied up or time intervals is irrelevant. It's all still dollar cost averaging.

The theoretical advantage of dollar cost averaging

When you invest anything into the stock market, you have no control over what the market is doing at that exact moment of investing.

Sometimes, the market may be down. So you invest your money at a relatively low basis. And then the market goes up. This is good for you. You bought the stocks relatively cheap and now they have increased in value. Or the market can keep going down more and more. This is bad for you.

Other times, the market may be up when you invest your money. If the market keeps going up, that is good for you. But if it goes down, that's bad. You bought at a high basis and now things have devalued.

And the most important thing to remember is that nobody has a functioning crystal ball when it comes to the stock market. So no one knows what will happen at the moment their money goes into the market or anything subsequent to that.

From this uncertainty, dollar cost averaging was born

If the short term stock market is unpredictable, then investing a large lump sum presents risks. Of the 4 possibilities above, there's a 50% chance of your investment not doing what you want it to do.

However, splitting up your investment and investing it over time theoretically could help mitigate those risks. Sure, sometimes you would lose, but you still have more opportunities to win. And sheer odds would favor some wins over time.

It makes sense in a vacuum.

But which is actually better?

A fantastic 2023 paper from Vanguard called Cost averaging: Invest now or temporarily hold your cash? sought to answer just this question.

The researchers used the MSCI World Index as their index fund of choice to measure returns for 1976–2022. The authors found that lump sum investing outperformed dollar cost averaging 68% of the time across global markets measured after one year.

They also studied the performance of lump sump and dollar cost averaging of an initial $100,000 investment over 1 year across three asset allocations: 100% stocks, 60% stocks/40% bonds, and 40% stocks/60% bonds. In most historical market environments, they found that investors would have been better off investing the lump sum.

In fact, the longer the time horizon, the more favorable were returns with lump sum investing.

Further, this overall finding of the superiority of lump sum investing has been demonstrated in multiple other papers as well.

An important note

The researchers also looked at a few other key questions with important outcomes for investors.

First, if investing a lump sum just seems too scary for an investor, investing via DCA still outperformed holding the money in cash 69% of the time. So it's important to invest. And if the only way you will invest is via DCA, then just do that. Even if lump sum investing could get you a slightly better performance. For comparison, lump sum investing bested holding cash 70% of the time.

And second, very risk averse investors may be better off using a cost averaging strategies based on utility models created by the authors. But we are talking like way, way risk averse. And if you have a relatively good time horizon before retirement, this probably shouldn't be you.

What does this mean for us in the real world?

As a general rule of thumb, physicians should aim to save and (ultimately) invest at least 20% of their gross income. However, in the large majority of cases, investing all of that 20% at once is not a realistic option for most of us.

So, in general, most investors practically do some hybrid form of dollar cost averaging and lump sum investing.

Take me for example.

I essentially dollar cost average into my 403(b) and 457 as they are taken out of my biweekly paycheck. I also dollar cost average into my taxable account as I automatically transfer a certain amount into it from my checking every month.

However, for my backdoor Roth IRA, I lump sum invest by putting the full allowable amount in at one time.

But what this also means is that if I ever receive a large sum from something, I would know that investing it in a lump sum would be a better financial move than dollar cost averaging it into the market.

And you will similarly find what blend practically works for your situation!