When I worked on Wall Street, Valentine’s Day was one of the best days of the year. Not because of the chocolates or the romantic dinner. No, Valentine’s Day was typically the day when the annual bonus checks would hit our bank accounts! After splurging on something nice, there was still a decent amount of cash left to invest.
A common question among physician investors is whether to invest a large cash amount in a single lump-sum or in small amounts over time. The latter option (“dollar cost averaging”) is quite popular. The large cash amount could be an annual maximum contribution to a 401K, a year-end bonus, or an inheritance.
Benefits Of Dollar Cost Averaging
- Smooth out average price: It feels natural to dollar cost average. Just as we are conditioned not to “put all of our eggs in one basket”, it seems strange to invest a large lump sum all at one time. With dollar cost averaging, you purchase shares at a range of prices (some low, some high). This feels better than buying all the shares at one price.
- Able to buy at lower price if the stock market falls: With dollar cost averaging, you can ease your way into the market. If the market falls, you are able to purchase shares at a lower price than if you bought everything in a single lump sum.
- Can say you bought some stock at the bottom: When a stock is falling, you worry that the stock may fall further after you purchase the stock. As the market adage goes, “Don’t try to catch a falling knife.” By dollar cost averaging, you will purchase the stock slowly over a period of time (for example, a year), and you may be able to purchase some shares at the market bottom. When the stock eventually rises, you can brag to your friends that you bought some shares at the bottom.
Benefits of Lump Sum Investing
- Get money into the market as early as possible: Stocks rise on average, so it would make sense to get into the market as early as possible, instead of leaving some money on the sidelines in order to dollar cost average.
- Able to buy at lower price if the market rises: While most investors are worried about putting all of their money into the market at once, you’d be better off investing in a lump sum if the market rises. After all, you are investing because you think the market will go up in the long-term, right?
- You can earn dividends for a longer period of time: Dividends are a significant portion of your overall stock market return. By being in the market earlier with a lump sum investment, you are able to earn additional return through dividends.
Historical Analysis of Dollar Cost Averaging vs. Lump Sum Investing
For this analysis, I took historical stock market prices of the S&P 500 from Yahoo Finance, starting from January 1950-February 2017.
For each month, I simulated the cost of buying the S&P 500 using a lump sum investing or dollar cost averaging approach. For the lump sum investing approach, I purchased all the stock upfront. For the dollar cost averaging approach, I split up the purchase price into 12 equal monthly purchases over one year.
How did this turn out? In the 795 simulations, 71% of time it was cheaper to purchase the stock using the lump sum method, and 29% of the time it was cheaper to purchase using the dollar cost averaging method. On average, you paid 3.8% more to purchase the stock using dollar cost averaging compared to buying all the stock upfront. This doesn’t even include the dividends you would earn by investing the money upfront. Assuming a historical dividend yield of 3% (currently 2%), you would add 1-1.5% in additional return with the lump sum approach. In summary, dollar cost averaging is 5% more expensive than lump sum investing.
The results of this analysis is not surprising. Based on the stock market going up 8% historically, dollar cost averaging over 1 year will cost, on average, 8% / 2 = 4% since the money is in the market for 6 months less than the lump sum method.
If you are investing in the stock market, you believe that the stock market will rise over time. You can’t predict whether the market will go up or down over the next year, but you know on average, it will rise. So dollar cost averaging is a losing bet. You may regret lump sum investing about 30% of the time when it does worse than dollar cost averaging, but on average (pun intended) you will come out ahead.
What do you think? Do you favor dollar cost averaging or lump sum investing?