What is Dollar Cost Averaging (DCA)?
Dollar Cost Averaging (DCA) is an investment strategy in which the investor divides up an amount of investments across equal periodic purchases in their portfolio. For example, an investor may choose to invest a lump sum of $10,000 across a DCA period of 10 months. This would mean she invests $1,000 monthly until she reaches her goal of $10,000 in purchased shares.
What is Lump Sum Investing (LSI)?
Lump Sum Investing (LSI) is an investment strategy in which the investor invests a “lump sum” of cash. Unlike DCA, in which investments are spread out across a set period, LSI invests the entire amount at the start. This is seen by many as inherently more risky, as an investor might time the market wrong and invest a large amount of money right before the market takes a dive. In this line of thinking, an investor would lose significantly more on a lump sum investment rather than an averaged-out investment.
Historical LSI vs. DCA Results
While in theory DCA might prevent large losses as investments are spread out across different periods, reducing the risk of entering the market before a drop with a lump sum, in reality, this does not often come to bear. In a report by PWL Capital, LSI and DCA were analyzed over 10-year historical periods in six global markets. The report found that LSI beat DCA around two-thirds of the time, and had a positive annualized return difference of 0.38%.
The report also analyzed the performances of DCA during the 10% worst historical LSI outcomes, during historical bear markets where markets drop 20% or more, and when stock prices are high relative to history. In this analysis, LSI outperformed DCA a majority of the time.
In other words, LSI not only outperforms DCA when all historical outcomes are considered, but also outperforms DCA when LSI performs the worst, when the market is bearish and experiencing drops of 20% or more AND when stock prices are high.
Other reports also come to similar conclusions. Studies by Vanguard conducted both in 2012 and more recently in 2023 showed that LSI outperformed DCA around two-thirds of the time.
Why Use DCA at All?
If there is so much evidence showing that LSI outperforms DCA the majority of the time, and DCA leaves so many gains on the table, why employ DCA as an investment strategy at all? As both the report by PWL Capital and Vanguard explains, DCA is sometimes necessary from a psychological perspective. For many investors, investing in a stock and watching it fall is more psychologically painful than not investing in a stock and watching it rise. This emotional bias is known as loss aversion. For this reason, many investors choose to employ DCA as a way to ease this psychological pain.
If DCA is used in this way as a psychological remedy, it may be a reasonable strategy. However, if you’re able to tune out the noise of daily and monthly variations, and you know you’re investing for the long haul, then we strongly recommend lump sum investing.