It is common knowledge that lottery winners have frequently proven to be ill-equipped at handling large windfalls. Among the best pieces of advice for freshly-minted millionaires: “Avoid sudden lifestyle changes”. In other words, holding demolition derbies with your high-priced car collection on the racetrack encircling your mansion may not be the most constructive use of wealth.
Though usually not on the same scale, many ordinary folks also find themselves with sizable cash payouts throughout the course of life due to bonuses, retirement plan distributions or inheritances. For the prudent, choosing a long-term savings plan over a Lexus is the easy part. Deciding how to invest the funds is another matter entirely.
We are often asked in such cases, “Should I put it all into the market now or spread it out over time?” The latter method, known as Dollar-Cost Averaging, invests equal portions of the original amount at regular intervals (e.g. monthly). It is commonly touted in the financial press as a less-risky option than making a single investment. While this is obviously true when stocks are declining, most of the time Dollar-Cost Averaging just doesn’t work.
The financial crisis would have been a good time to Dollar-Cost Average. $3,000 plunked into the market in October 2008 would have fallen to $2,342 by the end of December. Alternatively, buying $1,000 each month from October to December would have resulted in a year-end balance of $2,729 (almost 17% better than the lump sum).
Past performance is no guarantee of future results. Indexes are not available for direct investment. The S&P 500 is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ.
This is just one three-month period. Changing the start date from October 2008 to March 2009 (the beginning of the recovery) provides a much different answer. In fact, when we looked at every 3-month period from 1926 to June 2013, we found that the lump sum investment would have beaten Dollar-Cost Averaging 64% of the time.
Increasing the length of the investment period only widens the disparity. Dollar-Cost averaging over 12 months returned less 72% of the time; a 36-month strategy returned less 81% of the time.
There is a simple explanation for the lump sum advantage: Historically, the market goes up more than it goes down. And because stock values increase on average over time, more often than not it has been disadvantageous to delay purchases (the longer you wait, the more disadvantageous).
Unless the short-term direction of the stock market is known with certainty (and it never is), the decision to Dollar-Cost Average is purely an emotional one. Fear of an immediate drop in value causes many to spread out their purchases over time, though history indicates otherwise. Time in the market is what has historically produced a higher probability of success…certainly more so than playing the lottery.
Aaron Pettersen, CFA, CFP®