As with anything investment-related, see my disclaimers. Investing involves risk. My analysis is provided solely for entertainment purposes and in no way do I recommend any course of action. Don't trust random idiots like me on the internet for investing advice. Or for anything else, for that matter.
There’s no shortage of market pundits predicting impending doom. The current trend of prophecy is pointing to astronomical price-to-earnings ratios and how calamity ensued the last time this happened.
If I’m an investor with a lump sum to invest, what do I do? The last thing I want to do is drop it in an overheated market, only to have its value plummet when doom arrives. On the other hand, how will I know when it is time to get back in?
In other words, can I time the market? (short answer: not really).
I’m currently asking myself this question. I maxed out our 2020 IRA contributions last October, and I already maxed out our 2021 contributions in January. $6k x 2 people x 2 years worth of contributions = $24,000.
And all of it’s sitting in cash.
Dollar Cost Averaging
One approach to get that money to work is through dollar cost averaging, or DCA, a process of spreading out a lump sum into periodic investments. I could ease into my target investment by spreading the $24k across the year in twelve equal payments of $2k. As the price fluctuates during the year, sometimes I’ll be buying at higher prices, and sometimes at lower prices. At the end of the year, I’ll be fully invested and my “cost” will be the average across all the payments.
Most of us will end up using dollar cost averaging throughout our accumulation phase, dribbling contributions in paycheck after paycheck, year after year. This unintentional dollar cost averaging should take some worry and fear out of the young investor.
A different approach is to value average, or VA. This approach, like DCA, uses periodic investments. But instead of equally sized contributions, instead the focus is on the current balance. If the current balance is less than LumpSum/NumberOfPeriods * CurrentPeriod, then you increase that period’s contribution until the balance is equal. You do the opposite if the balance is bigger. This tends to increase contributions when the asset value has pulled back (i.e. buy low), and decrease contributions when the asset has increased in price (i.e. avoid buying high). Once your total contributions exceed your original lump sum, then you stop contributing for the year. And any left over contribution is contributed in the final period.
Let’s look at 2020 as an example where we are easing $12k into VTSAX over the year. The following table includes the price of VTSAX on the first of each month, the price, that month’s contribution, and then the total contribution. In the final month, December, we make an additional contribution to complete the year:
You see that some months our contribution is reduced because the market has gone up over the year. In November, we didn’t even make a contribution, things are going so well. And in December, we still have more than $2k left over from our original $12k to invest.
Comparing The Approaches
The following is a graph comparing the annual returns of VTSAX over the past twenty years. The blue line is the lump sum approach, investing the complete amount for the year on January 1st. The red line is spreading the lump sum into twelve equally sized payments. The yellow line is value averaging, explained above. Notice that both DCA and VA is a two-edged sword: it reduces downside rates of return, but also reduces upside returns:
Here’s my analysis if you want to take a look.
Time In Market Versus Timing The Market
Another way to look at that graph is asking “how many times does the DCA annual return beat the lump sum approach?” In only five of the last twenty years did DCA have a higher return than the lump sum approach. Ditto for VA. In other words, three quarters of the time the investor would have been better off just putting the whole lump sum into VTSAX instead of worrying about buying into an overheated market.
Why? Because at the end of the day, time in the market has more impact than timing the market. In other words, in every year, the investor had the whole amount working for them the entire year with the lump sum approaches, where the other approaches had roughly half as much, on average, working for them through the year. This can make a huge difference.
What about the difference between DCA and VA? Over the past twenty years, VA beat DCA nine years out of the twenty and lost to DCA eleven of the years. But not by much. Value averaging is not a clear winner over DCA, nor is it a clear loser. It’s mostly the same thing, with a lot more effort to calculate it.
Most of us don’t start off with a lump sum to invest when we start our investing life. Our contributions are spread over our earning lifetime, naturally dollar cost averaging. But if you are faced with a lump sum to invest, you’re probably better off not worrying about it losing value the day after you invest it, and simply plunk it all down into a broad market index fund today. Stop worrying and get all of it working for you sooner than later.
Before I finished this article, I swallowed my own medicine and I’m now happy to say that all $24k is now invested across several Vanguard index ETFs, including VTI, VEA, VWO, VSS, and VNQ (not endorsements, but fit with my investing plan)
Where do you stand on lump sum versus dollar cost averaging or value averaging? I’d love to hear about it in the comments.