Toe-Dipping or Cannonball: Which Investing Approach Is Better?Submitted by Bernhardt Wealth Management on January 13th, 2020
Every kid knows that when you’re jumping into a pool full of cool water, there’s only one way to do it: “Cannonball!” You grab a deep breath, take a flying leap, and hit the water all at once. Though some insist on the incremental approach—first one foot, then the other, then gradually wading into deeper water—at some point you’ve got to be “all in” if you plan to swim.
Dollar-cost averaging, the investing equivalent of the “getting your feet wet” gradual approach, gets a lot of notice in the consumer press. Mutual fund marketing departments have also touted this approach for years in their efforts to sign investors up for monthly, payroll-deducted subscriptions, whether for the company 401(k) plan or some other program involving smaller investments at regular intervals.
The theory makes sense, on its surface: instead of putting a lump sum of cash to work in the investment markets all at once, you spread out your investing over a period of weeks or months. That way, if the market goes down while you’re investing, your next scheduled investment will be buying stocks at a bargain. But does the evidence support the theory? Is dollar-cost averaging really superior to lump-sum investing—the “cannonball” approach—in terms of investment performance?
A study by the Vanguard Group suggests that lump-sum investing may actually offer superior performance. In the study, which looked at rolling 10-year periods in the U.S. market (1926‒2011), the UK market (1976‒2011) and the Australian market (1984‒2011), lump-sum investing generated a higher total return than dollar-cost averaging 67 percent of the time. Given the fact that historically, stocks tend to go up more often than they go down, this makes sense. Another study by the Seeking Alpha organization, noted that over the last 27 years, a 12-month, lump-sum annual investment in the S&P 500 provided an average return of 8.77%, while using dollar-cost averaging over the same period would have returned only 4.77%.
Certainly, any type of systematic investment program is better than perennially sitting on the sidelines, waiting for the perfect moment to get into the game. Investments purchased gradually over time are far superior to no investments at all. But for those who have lump sums available for investment, either on a single occasion or at recurring intervals such as annually, it may make more sense to go “all in” rather than using the gradual approach as a hedge against unexpected market movements. As we have said consistently for years, no one can predict market movements over any particular period. Rather than trying to control factors that are beyond anyone’s control with techniques such as dollar-cost averaging, it may improve overall portfolio performance to simply allocate the lump sum according to the investor’s asset allocation and rebalancing strategy. When executed according to a pre-determined strategy, the “cannonball” entry may actually be the prudent approach.
If you have questions about dollar-cost averaging, asset allocation, long-term investment strategy, or any other financial topic, we would deeply appreciate the opportunity to help you find the answers you need.