If you've just come into a whole lot of cash with no plans for its immediate use, you probably know it's best to invest that money. Whether you recently downsized your home, received a significant bonus at work, or just received an inheritance, putting that cash to work in the stock market is one of your best opportunities to grow your wealth.
Investors in that situation often hear advice to dollar-cost average into the market. Instead of investing the lump sum all at once, they may be better off investing a little bit at a time over the course of a year or two. The idea is to hedge against the risk of the stock market going down.
Generally speaking, that's not the best advice for most investors. Here's what you're missing out on by dollar-cost averaging.
Why dollar-cost averaging makes no sense
We know stocks as a group increase in value over time. When the market drops, it always comes back and sets new highs. Sometimes it takes awhile to recover, but typically the recovery is swift.
Intuitively, then, it makes sense to invest as much as possible as early as possible. Maybe you've heard the adage that "time in the market beats timing the market."
So why then would anyone dollar-cost average? Because they want to mitigate the risk of putting all their money in at a peak. They'll have buyer's remorse if they put their big windfall into some stocks early and then see the market crash over the next six months.
But if you can't handle big swings in your portfolio, you're better off adjusting your asset allocation to fit your risk profile rather than dollar-cost averaging. Indeed, once you've finished dollar-cost averaging, you may find your final portfolio is too aggressive for your risk tolerance.
Here's what you're missing out on
Holding a lot of cash on the sidelines means you're probably missing out on returns. In exchange, you get less volatility in the value of your total portfolio, as cash is typically shielded from big swings in value.
Throughout history, if you had invested your windfall into an S&P 500 index fund (let's pretend that was possible), you'd have earned an average annualized real return of 7.8% over any given two-year period. If instead you dollar-cost averaged into the index fund over two years, you'd earn just 4.2% annualized on average. The difference might not sound like much for just a couple of years, but when you're talking about a significant amount of money, it adds up.
This chart shows the minimum, 25th percentile, 75th percentile, and maximum annualized returns for two-year periods for various investing strategies: lump-sum investing in the S&P 500, dollar-cost averaging into the index over one year, investing a lump sum into a portfolio of 82% stocks and 18% Treasury bonds rebalanced annually, dollar-cost averaging over two years, or investing in a portfolio of 49% stocks and 51% bonds rebalanced annually.
While lump-sum investing produces the highest average returns, it also has the widest range of outcomes. The big block in the middle shows 50% of outcomes fall between an annualized return of 0.23% and 16.18%. Dollar-cost averaging into the index over two years produces much lower volatility.
But as you can see, you can achieve the same level of volatility by lump-sum investing in an appropriate asset allocation while producing better returns. An 82%/18% portfolio produces the same standard deviation in returns as dollar-cost averaging over one year, and a 49%/51% portfolio does the same for a two-year timeline. But those two portfolios produce average returns about 1 percentage point and 1.3 percentage points higher for the one-year and two-year timelines, respectively.
That's really what you're missing out on by dollar-cost averaging. On a $100,000 windfall, that's at least $1,000. And if you let the money continue to compound for years to come, that extra $1,000 can turn into a lot more.