Sometimes the planets align and through good fortune or good management you receive a large sum of money. If you choose to invest your windfall, what is the best approach to take? Invest all at once, or make smaller investments regularly over a period of time – say each month for 12 months?
Spreading investments out equally over time takes advantage of dollar cost averaging. Dollar cost averaging means that you buy fewer units when markets are high, and more units when markets are low. This results in your average cost (total cost/total number of units) being less than the average cost of the units. Try it out in a spreadsheet if you don’t believe me! It’s a great approach if you’re investing regularly (say a portion of your salary each month), but how does it stack up v having a lump sum available to invest on day 1?
Vanguard, the giant US investment group who manage over $4 trillion(!) in assets, carried out some extensive research on this topic, looking at the difference between lump sum investing and dollar cost averaging. The research covered three markets (USA, UK, Australia), different investment mixes (ranging between 100% equities and 100% bonds), and different periods for the dollar cost averaging strategy (from 6 to 36 months). And then the results were compared for investment durations of between 5 and 30 years, and across rolling periods from 1926 to 2012. In other words, it was a pretty comprehensive study!
The results showed that making a lump sum investment will result in higher returns compared with dollar cost averaging around two thirds of the time. The outcomes were also remarkably consistent across markets, investment mixes, dollar cost averaging periods, and investment timeframes. Where dollar cost averaging does come out ahead is in situations where a lump sum investment is made just prior to a significant market downturn – ie worse case scenarios.
If you do have a lump sum to invest, my advice is aligned with the findings of the research. It’s very hard to predict when markets will surge or tumble, so the wisest move is usually to invest immediately, and gain exposure to the markets as soon as possible, for as long as possible. It doesn’t guarantee the best outcome, but it does put the odds firmly in your favour.
PS. If you are interested in the Vanguard study, you can find it here.