How to Invest a Lump Sum of Money?

A common question in Financial Planning is for investors to wonder if they should invest a lump sum of cash now or dollar cost average this money into the market? Financial theory and historical evidence suggest that the best way to invest this sum is all at once into a portfolio that fits an investors risk tolerance. However, most investors choose to put their money to work over time, using a system that is referred to as dollar-cost averaging.

If we dive into the research and look at history and financial theory, the conclusion is drawn that immediate investment will, on average, outperform a systematic implementation. This is based off of investing in a passively managed global portfolio. This conclusion supports the ideas of financial theory and market efficiency.

Dollar-cost averaging also presents a strong argument for most individuals as it provides protection against regret. Most view the dollar-cost average approach as a risk reduction strategy given that an immediate market loss following a large lump sum investment will give many people discomfort in their asset allocation.

Vanguard published an article titled "Invest now or temporarily hold your cash" detailing this decision making process and also how a portfolio would have performed. Let's take a look at their findings:

As one can see the data will show that the investing a lump sum has statistically outperformed a dollar-cost average approach. But for most investors that are sitting upon large sums of cash, the risk associated with a market downturn are too high to stomach. We do not recommend trying to time the market but to ease the emotional roller coaster of market volatility, in most cases, is very important. Therefore for most investors the solution is typically to dollar cost average the money into the market place, even though according to statistics it is not the most efficient way of investing the money.

Vanguard also studied the cost of the protection in the argument for dollar cost averaging. To do this, the rolling 12-month returns for a balanced 60% equity, 40% fixed income portfolio were looked at. Then they took the high and low distribution to divide them into deciles. They then calculated the average returns of immediate investment and dollar-cost averaging strategies in each decile. Figure 2 below displays the return differences between both strategies in each global market. For example, they took the worst decile of portfolio performance in each country for the worst years and found that an immediate investment underperformed dollar cost average investments over that 12-month period by an average of 8.3% in the US, 7.7% in the UK, and 7.8% in Australia.

In deciles 1 and 2 (and 3 for the United States and Australia), the higher returns from a systematic investment plan can be thought of as the payoff from such downside protection. The opposite is true in stronger markets. In these cases, the systematic investment’s underperformance can be thought of as the “cost” of such downside protection. These costs may be reasonable if a systematic implementation plan helps an investor overcome any paralyzing fears of regret.

To conclude, the most important decision, which like most decisions in asset management comes down to behavioural finance. We know that over the long term, the lump sum is statistically likely to outperform a dollar-cost average approach. But we need to understand the risk factors associated with the decision at hand. Assuming that the market risk premium still exist, it makes the most sense to invest in the market over holding cash. Like most decisions the key is to have a conversation with your advisor to determine which approach makes the most sense for your individual situation and structure a plan accordingly.

References Shtekhman, Anatoly, Christos Tasopoulos, and Brian Wimmer, 2012. Dollar-Cost Averaging Just Means Taking Risk Later. Valley Forge, Pa.: The Vanguard Group.