Lump Sum Investing vs Dollar Cost Averaging: An Analysis for a €1 Million Investment in Passive Global Equity Funds

I’m doing a training session this week for a group of employees of Ireland’s largest fruit companies; I’m thinking I’ll base it around the concept that your Euros are like oranges; we should mind our hard-earned Euros just as if they were delicate oranges, and that we gotta ensure that we squeeze the best from them – what you reckon!?

Anyway. this week I’ll share;

• Pros and cons of Lump Sum Investing and Dollar Cost Averaging
• A ‘look-back’ to see which has been most profitable for €1m invested in Ireland
• A look-forward to see which might be most profitable in future
• Investing when markets are deemed to be ‘High’
• My conclusion

Getting Invested

When it comes to investing a large sum of money (we’re assuming from cash/deposit), there are two commonly debated strategies: Lump Sum Investing (which we’ll call LSI) and Dollar Cost Averaging ( which we’ll call DCA). Both methods have their pros and cons, and each appeals to different types of investors, depending on their risk tolerance, timelines, market expectations, and financial goals.

In this blog post, I’ll dive into the definitions of Lump Sum Investing and Dollar Cost Averaging, weigh their advantages and disadvantages, and illustrate a specific scenario comparing these two strategies for a €1 million investment in diversified passive global equity funds.

Definitions

1. Lump Sum Investing (LSI)

Lump Sum Investing refers to investing the entire amount of money, in this case €1 million, on Day 1, into the selected investment vehicle. The idea behind LSI is to immediately expose the full capital to potential market gains, with the assumption that markets generally rise over time.

2. Dollar Cost Averaging (DCA)

Dollar Cost Averaging is an investment strategy where you invest a fixed portion/amount of your total sum regularly over a period of time. In our scenario, you would invest €1 million incrementally, say €250,000 every six months over two years. The objective of this is to try reduce the impact of volatility by spreading the purchase prices across different time periods. One is trying to avoid ‘catching a falling knife’!

Pros and Cons of Lump Sum Investing

Pros:

1. Full Market Exposure:
   By investing the full amount at once, you immediately take advantage of potential market growth. Historically, global equities tend to increase in value over the long term, so full exposure can potentially lead to better returns.
2. Simplicity:
   LSI is a straightforward, one-time transaction. You don’t need to worry about timing your next entry point, as you’re fully invested from the outset. Done and dusted.
3. Potentially Higher Returns:
   Research has shown that markets are generally upward trending. By investing a lump sum, you allow all of your capital to grow in line with market gains from the start. In fact, studies suggest that in two-thirds of the cases, LSI tends to outperform DCA over long periods.

Cons:

1. Market Timing Risk:
   If you invest your €1 million in a lump sum just before a market downturn of say 20 or 30%, you could experience significant short-term paper losses. Timing is important in LSI, and it’s impossible to predict when the market will go up or down in the short term.
2. Psychological Stress:
   Large market fluctuations could create anxiety for some investors who aren’t prepared for short-term volatility, or who are new to investing in global equity. If the market falls after your investment, it can be disheartening to see a large portion of your wealth decrease in value. Unless the investor is experienced and/or has a professional advisor to help them keep their long term perspective, it can lead to knee-jerk reactions and people consolidating loss-positions. These can then be impossible to get out of. If that happens these investors can become disillusioned with investing – having other knock-on effects and huge opportunity cost for them.
3. Illusion of Overconfidence:
   LSI requires conviction in the markets long term trajectory. While data favors LSI in many cases, investors who get it wrong may feel a strong sense of regret, especially if their portfolio suffers significant losses in the early stages of their investment. Not fun!

Pros and Cons of Dollar Cost Averaging

Pros:

1. Reduced Volatility Risk:
   By spreading out investments over time, DCA potentially allows you to reduce the chance of making a large investment just before a market downturn. You purchase more shares when prices are lower and fewer when prices are higher, smoothing the cost of your investment over the duration of your phased investment. This can be a pro or a con of course!
2. Psychological Comfort:
   This really is the sole rationale for many. DCA helps nervous investors avoid the deemed anxiety of putting all their money in the market at once. It also reduces regret if the market experiences a short-term drop after the first tranche of investment. Of course, it will still hurt, but it might just hurt less!?
3. Disciplined Approach:
   DCA enforces a disciplined investment habit, as it focuses on consistent contributions over a set period of time. This method in theory can help long-term investors stay committed to their plan regardless of short-term market fluctuations.

Cons:

1. Opportunity Cost:
   If the market consistently trends upwards during the two years you’re gradually investing, DCA could result in lower overall returns. By keeping part of your money out of the market, you miss out on potential growth.
2. Complexity and Monitoring:
   DCA requires ongoing management. You need to decide how much and how often to invest, and you must monitor your investments regularly. It’s not a one-and-done strategy like LSI, which can be time-consuming. If the markets fall dramatically for example, and you are scheduled to invest another €250k, can you stomach it, or will a nervous investor balk at the idea, and potentially miss a once-in-a-lifetime bargain!? This is a real risk and real potential con if the investor is not supported properly.
3. Lower Returns in Bull Markets:
   In a rising market, DCA will underperform LSI, as you would be continuously investing in higher-priced equities over time. This dilutes the potential for gains compared to investing a lump sum when prices are lower. The potential to miss the bus entirely is a very real con.

Example Scenario: €1 Million Investment in Irish Passive Global Equity Funds Over Two Years

Lump Sum Investing Scenario – Past 2 Years

Let’s assume you invested the entire €1 million end September 2022, in a sample Vanguard Developed Global Equity index fund. Over the next two years, that Global Equity fund has had total returns of c37%.

• By the September 2024, your investment would have compounded to roughly €1.37m.

Dollar Cost Averaging Scenario

Now, assume you divide the €1 million into 8 investments of €125,000 each, made every 3 months for the past two years, started in September 2022.

• By the September 2024, you are fully invested, and your investment would have compounded to roughly €1.22m.

Dollar Cost Averaging cost you c€150,000 of total return in that scenario.

Sure, the perceived risk was lower, and you possibly stayed invested where you might not otherwise would have (possibly!?). But, was it worth it? Only you can answer that.

If the outcome had been in favour of DCA, you’d likely have said ‘Oh God yeah!’.

10 Year Analysis

Now we will all acknowledge that 2 years is a very short timeframe. Plus, we’ve in the middle of an Epic Bull Market! So DCA was always gonna come off badly there. But the point is, nobody knew 2 years ago that we were going to have such growth over the coming 2 years.

There were plenty of folks sitting on cash, record-highs of cash sitting in deposits, 153Bn to be exact as of earlier this year. We saw many turning to Money Market Funds to try get something, and doing so with a long-term lens. People were and are still often fearful or reluctant about getting ‘properly invested’.

But how about randomly looking at the past 10 years? In 2014 we were still trying to recover from Global Meltdown, we then had Covid market melt-down, and again in 2022 markets had a meltdown. So how did LSI and DCA do over that timeframe? Lets see….

€1m Lump Sum Invested September 2014 to September 2024:

You invested lump sum €1m at the end of September 2014. And with the guide of a professional financial advisor, you held firm during the many scares we have had since.

As of end September 2024 you’re €1m is worth €2.9m (after fees before tax).

What about Dollar Cost Averaging?

€1m Dollar Cost Averaged September 2014 to Sept 2016, and then left invested till 2024:

We assume you get your €1m invested on a phased basis in year 1 and 2. We model that you invested €125k per Quarter from Sept 2014 to Sept 2016, (during which period the market was up and down and up and down, but up c18%!). And from 2016 to 2024 you simply sat on your hands, and ignored Covid market madness and 2022 market madness!

As of end September 2024 you’re €1m is worth €2.5m (after fees before tax).

In that scenario, DCA cost you c€380k of total returns. Simply because you did not get the full €1m into the diversified global equity fund on day 1 September 2014.

Paddy Delaney

What About LSI and DCA when Markets Are ‘High’?

The inimitable Nick Maggiulli in the US looked at the 2-years outcomes from 1960 to 2022 for the S&P, comparing DCA and LSI. He did this against the ‘market valuations’ at these times.

To measure valuations and whether the market was ‘high’ or ‘low’ he used the Cyclically Adjusted Price Earnings Ration, or CAPE ratio. It is a commonly used measure, and like any other, it ain’t perfect.

Interestingly, the size of DCA’s underperformance does shrink as valuations get more extreme (as measured by CAPE ratio and percentiles). However, LSI has outperformed by 6% over 2 years on average over all 2-year rolling periods where valuations were considered ‘high’.

As Nick suggests, there have been a relatively small number of periods where the CAPE ratio has been at it’s highest valuations, so we run into sample size issues when looking at long terms trends. But the available data points to LSI being the favoured route over the past 60-odd years.

Conclusion: Which Strategy Should You Choose?

In the 2 recent scenarios, Lump Sum Investing yielded higher returns and better outcomes for investors.

Dollar Cost Averaging under-performed, and cost you returns.

Over the past 60 years of S&P data, Lump Sum Investing delivered better returns.

The difference is due to the fact that LSI allows the full amount to benefit from market growth and participation for a longer period. Bottom-line. It’s all about ‘time in the market not timing the market’.

However, DCA helps protect against some short-term volatility and some of the risk of entering the market at an inopportune time. But those are short-term issues. Long term, these ‘benefits’ are less relevant.

If you’re confident in the long-term growth of global equities and can stomach potential short-term losses, Lump Sum Investing has been the better option for maximising returns. The evidence suggests so. On the other hand, if you’re worried about market timing or prefer a more cautious approach, Dollar Cost Averaging offers a method to ease into the market with reduced risk. This might be the way to go if you are nervous, inexperienced or haven’t got a professional investment counsellor or advisor to support you along the way.

Ultimately, the right strategy depends on your financial goals, risk tolerance, and how comfortable you are with market fluctuations. Whichever approach you choose, investing via passive and diversified equity index funds has offered an exceptional way to protect and growth wealth for thousands of Irish investors. However you invested in it, DCA or LSI was kinda secondary!

Just make sure, whichever way you dice it – that the juice is worth the squeeze!!

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