Publications

- February 1, 2019: Vol. 6, Number 2

Drip-drop vs. big drop: An analysis of whether dollar-cost averaging or lump-sum investing offers better performance to investors

by Gregg Fisher

Dollar-cost averaging is a strategy recommended by many professional money managers as a means of gradually allocating an investor’s portfolio into risky assets, such as equities, to avoid the perceived risk of investing at the “wrong” time. But do dollar-cost averaging strategies perform better than simple lump-sum investing?

Given the long-term bull market and high equity valuations, a growing number of investors have become wary of putting large blocks of cash to work in the market all at once. Instead, they invest smaller amounts of cash at regular intervals over an extended period of time. This process, called dollar-cost averaging (DCA), is a strategy often recommended by investment advisers for risk-averse clients. But does this strategy have any investment merit, or is it done primarily to allay the fears of investors? We compared the historical performance of DCA with a lump-sum investing strategy where the portfolio allocation into stocks is made at a single point in time.

Given that we know when DCA would work best, it’s intuitive to think that a DCA strategy would, more often than not, fail to benefit investors. This is because we expect that, in general, markets move up; the S&P 500 Index yielded positive returns in over 60 percent of the months between Jan. 1, 1926, and Dec. 31, 2017, and in over 70 percent of the years between 1926 and 2017. However, intuition is not enough to validate the claim that lump-sum investing strategies (investing all available investable assets at once) perform better than DCA strategies. Several studies provide statistical and empirical evidence supporting the underperformance of DCA. Additional research conducted by Gerstein Fisher confirms that DCA strategies underperform lump-sum (LS) investing the majority of the time.

To compare performance, the two strategies were back-tested between Jan. 1, 1926, and Dec. 31, 2017. The initial portfolio was assumed to be $1 million cash, and the only investment available was the S&P 500 Index. In the DCA strategy, one-twelfth of the initial portfolio was invested each month, at the beginning of the month. This meant that the entire $1 million was invested by the end of the 11th month (i.e., by the beginning of the 12th month). The LS strategy took the entire $1 million portfolio and invested the full amount at the beginning of the first month.

For the purposes of this study, we assumed zero transaction costs. This assumption favors the DCA strategy because, by design, the DCA strategy involves much more trading, which results in higher transaction costs. We analyzed every rolling 12-month period between Jan. 1, 1926, and Dec. 31, 2017, that had a corresponding 20-year period to determine whether the DCA or LS strategy outperformed. The result: LS investing outperformed the DCA strategy in 633 out of the 865 periods (73 percent of the time). In other words, in nearly three out of four 20-year rolling periods, one would have been better off investing a lump sum as opposed to using a DCA strategy.

On average, at the end of a 20-year period, an investor who chose the LS strategy would have had $432,838 more than an investor who chose the DCA strategy.

Let’s consider the average ending dollar amounts over 12-month and 20-year rolling periods for both the LS and the DCA strategies. Because the strategies are fully invested by the end of the first year, both strategies have the same exact returns from year two through year 20. All of the outperformance is a result of the difference between the strategies during the first year; during this first year, the LS strategy is fully invested, and the DCA strategy is gradually invested. On average, over a 12-month rolling period (that had a corresponding 20-year period), LS outperformed DCA by $63,513. The $432,838 average difference at the end of the 20 years corresponds to this average difference of $63,513 obtained at the end of the first year.

It is interesting to note that in the instances in which DCA outperformed LS (27 percent of the time), the magnitude of that outperformance was less than when LS outperformed DCA. Specifically, during the 633 20-year periods during which LS did better than DCA, the average cumulative outperformance was $870,119 on the initial $1 million investment. During the 232 periods in which DCA did better than LS, the average cumulative outperformance was $760,258.

While these findings make a compelling case for a lump-sum approach over the long term, how do the results compare over shorter periods of weak market performance? We ran the same analysis for rolling 12-month periods over the decade between January 2001 and December 2010, when the S&P returned a mere 1.41 percent annualized with significant volatility along the way. Even over this “lost decade” for the equity markets, LS still beat DCA 64 percent of the time. An investor would have, in an average period, ended up with an incremental $12,847 (on an initial $1 million investment) by investing in a lump sum rather than using a DCA approach over this period.

Nonetheless, there is a common misconception among many investors, and even investment professionals, that DCA is a superior investment strategy in terms of risk management and even returns. Our research, in addition to several prior studies, has shown that this is not the case. If not, then why is DCA still a popular investment strategy?

One explanation may be investors’ aversion to risk. DCA strategies do result in lower volatility, which is a result of the assets staying in cash (little to no volatility) for a longer period of time. However, if the long-term asset allocation for an investor suggests a target equity level of ‘x’ percent, is it still appropriate to invest small portions of capital until the investor reaches the target equity allocation of ‘x’? The answer, according to Steven Thorley, is no. His research suggests that a buy-and-hold strategy, which would hold the target risky-asset allocation of ‘x’ percent from day 0, results in better risk-adjusted returns.

Given that the majority of academic and industry research shows the inferiority of DCA strategies (both in terms of risk and return) when compared with LS investing and buy-and-hold investing, is there any rationale for investors to feel more comfortable using a DCA strategy? Karyl Leggio and Donald Lien shed some light on this question. They suggest that DCA is a conservative investment strategy that is best suited for investors who seek a forced saving plan that will ensure they avoid consumption of earnings.

DCA has been a popular investment strategy for individual investors and is still recommended by many investment professionals. Although theoretical and empirical data demonstrate the inferiority of DCA investing compared with LS investing and buy-and-hold strategies over most historic periods, it is important to understand the underlying reasons that cause investors to choose DCA and some investment professionals to recommend DCA. Risk-averse investors, who may be unwilling to invest into risky assets all at once, find the more gradual approach of DCA strategies emotionally comforting. Investment professionals, such as financial advisers, find DCA to be an easy way of encouraging investors to save. As long as both individuals and professionals have well-informed and clear expectations for a dollar-cost averaging approach to investing their assets, it can serve a function in managing both market and behavioral risk, even if it is sub-optimal from a statistical perspective.

 

Gregg Fisher is the founder, head of research and portfolio strategy at Gerstein Fisher, and portfolio manager for Gerstein Fisher Funds. This column was excerpted from a white paper Fisher authored on the subject, which can be downloaded at this link: https://bit.ly/2BVEkOw

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