When considering how to invest a lump sum of cash, investors are faced with the question of how quickly to invest those funds. That decision can turn what is likely a positive experience (having funds available to invest) into an anxious one filled with fear:  What if asset prices drop significantly right after the money is invested? Is there a way to put this money to work that minimizes the risk of such an event?

In this situation, investors have three general options:

1. Put the money to work immediately.
2. Implement in stages by investing the portfolio gradually over a specified period of time (this is usually referred to as dollar cost averaging (DCA)).
3. Wait for an opportune time to invest. This is when an investor envisions a time in the future when expected returns will be higher than what the investor anticipates in the current market environment. In the meantime, the investor keeps the money in cash or very safe bonds.

Which approach is best?

We suggest the third option is the easiest to rule out – there is ample evidence that even experienced professional investors cannot successfully and consistently time markets, in either direction.

The choice between immediate implementation and stages is more nuanced.

Essentially, by utilizing a staged (or DCA) approach, the “entry point” when money is invested is transformed into a series of smaller investments, so the performance of markets immediately after investing has less impact on portfolio returns. This is the perceived benefit of DCA, and like most things in life, it comes with a cost:  investments have a positive long-term expected return, any time spent not invested, on average, represents a lost opportunity for potential returns.

Let’s break down option one and two above by looking at specific examples.

Putting the money to work immediately.

Assume an investor just inherited a large sum of money and invests 60% in stocks (represented in this analysis by the Russell 3000 Index) and 40% in bonds (represented by the Bloomberg Barclays U.S. Aggregate Bond Index). The average annual return of this portfolio from January 1979 to March 2020 was 10.77%.[1] For our analysis, however, the more relevant number is the monthly average return, which for this portfolio was 0.84% or 0.48% over Treasury Bills (widely considered the reference risk-free asset).

Implementing in stages.

What if this time the investor decides to invest a sixth of the portfolio each month over six months? What is the opportunity cost of this strategy? To analyze the tradeoff, the difference in returns between an immediate and a six-month DCA implementation after six months using rolling one month start periods from January 1979 to October 2019 were analyzed.  In other words, the return for a DCA implementation from January 1979 to June 1979 was subtracted from the return of an immediate implementation over the same six-month time period. That process was repeated a total of 490 rolling observations up to the final investment period of October 2019 through March 2020.

In about a third of the observations, using a six-month DCA approach improved the returns. In the other two thirds of cases though, the delayed implementation resulted in a lower average return.  Overall, the average difference in compounded returns was 1.31% – to the advantage of an immediate implementation.[2]

Additionally, if the portfolio is then held for the long term, this opportunity cost is also spread over a longer investment horizon, reducing the impact of DCA on average returns. Using the same six-month DCA versus immediate implementation methodology, if instead of taking the difference after six-months we look at the difference in annualized returns after ten years, the average annual difference was reduced to 0.33%.[3]  Another way to think of it:  the average difference in portfolio value after ten years was $2,624 to the advantage of immediate implementation for a $100,000 initial investment.

What about the other side of this trade-off – the benefit? Specifically, how effective is DCA in reducing the sensitivity of returns to when the investment is made?

To answer this question, we can look at the financial crisis of 2007-2009 and compare an immediate investment with the six-month DCA strategy at the market top (November 2007) and market bottom (March 2009). To compare the two, we will examine the annualized return on each portfolio through March 2020.

 

Annualized returns to March 2020
Implementation	From November 2007 (market top)	From March 2009 (market bottom)	Difference
Immediate	5.84%	10.45%	4.61%
Six-month DCA (1/6 every month)	6.24%	9.48%	3.24%
Difference	0.40%	-0.97%	1.37%

 

A few key points are worth highlighting. First, these numbers show that despite the implementation technique used, the subsequent performance of markets still has a larger impact on average long-term returns. In this case, investing at the bottom of the market resulted in annualized returns higher than investing at the top of the market by 4.61% and 3.24%, respectively, in the immediate or DCA implementation. By comparison, DCA changed the annualized return versus immediate implementation only by 0.40% and -0.97% respectively, in the market top and market bottom scenarios.

Secondly, the impact of DCA is asymmetrical:  -0.97% reduction in returns is in absolute terms more than twice the 0.40% improvement. This asymmetry holds over multiple time periods as well when looking at the difference in six month returns from January 1979 to October 2019.[4]

Remember, the market has a positive expected long-term return.

There were no announcements on the front page of The Wall Street Journal telling investors that November 2007 was going to be the market high or that March 2009 was the bottom. So, should an investor accept 0.33% in lower average annualized returns (using the example above) in order to smooth out by 1.37% the impact of a potential market crash? The answer is not formulaic and depends on each investor. But, having a good understanding of the tradeoffs is the first step towards finding the answer.

It is also important to consider the emotional aspect of investing potentially large sums of money, especially in a volatile market environment. Even though dollar cost averaging comes with a cost, it may be well worth it if it allows investors to execute their financial plan while taking emotion, guesswork, and stress out of the process. After all, the cost of sitting on the sidelines indefinitely and never implementing the plan is likely many times greater.

Appendix and Disclaimer

Indices are not available for direct investment and performance does not reflect expenses of an actual portfolio.  Past performance is not a guarantee of future results.  Actual results may be different.  Equity returns derived from the Russell 3000 Index, 1/1979 – 3/2020, Source: Russell data copyright Russell Investment Group 1995-2020, all rights reserved.  Fixed income returns derived from the Bloomberg Barclays U.S. Aggregate Bond Index, 1/1979 – 3/2020, Source: Bloomberg.  Cash returns derived from One-Month US Treasury Bills, 1/1926 – 3/2020, Source: Morningstar.

The percentage of positive and negative outcomes and the average difference in returns of 1.31% was found using an immediate implementation and six-month DCA analyzing the returns of a 60% stock portfolio comprised of the Russell 3000 Index and 40% bond portfolio comprised of the Bloomberg Barclays US Aggregate Bond Index from January 1979 through October 2019.  Returns for cash not invested during DCA simulated by One-Month US Treasury Bills.  The 10-year difference in average annualized returns found utilizing the same methodology for a period from January 1979 through April 2010.

[1] For a description of data, methodology and sources used, see disclaimer and appendix.

[2] 1.31% average difference calculated by averaging the difference between a six-month and immediate implementation for every start month from January 1979 to October 2019.

[3] Starting months analyzed were from January 1979 to April 2010.

[4] The average compounded return for months (Jan. 1979 – Oct.2019) when DCA was positive and negative were 2.67% and 3.14%, respectively.