So far we covered a few scenarios in terms of investment: little by little for the long term based on what you can save every month (e.g. I can invest every month 1.0K Euro and I have a 30 years time horizon) or a relatively bigger amount all at once for the short term (e.g. I have 30K and would like to get something out of it in the next 5 years when I plan to buy a house).
One possibility not covered until now is the following - I have a decent amount of money saved and I want to start investing it for the long term. What should I do? Here we are not going to discuss Active vs Passive investing or how to create an ETF portfolio - as these topics were covered already here and here. Rather, we are going to focus on the timing of the investment itself as there are two possibilities:
- Invest everything at once - this approach is called "lump sum"
- Invest a portion of the money at regular intervals (e.g. every month I invest 5K) - this approach is called "dollar cost averaging" (DCA)
There are of course pros and cons for both options: a lump sum exposes you to a timing risk - e.g. you invest at the peak and the market goes down after - but on the other hand you maximize your time in the market since you invest everything at once and as soon as you take the decision.
Dollar cost averaging allows you to spread the timing risk over a long time horizon but this means also your time in the market will be lower and that you will have part of your money not giving you any (or very little) returns until it is invested.
Which route should you take? First, the common wisdom and then the results of a study done in 2012.
In terms of common wisdom, the advice that is given the most and that I can relate to is to select your choice based on the risk of the asset class you are going to invest to:
- If you are going to invest in shares or equity ETFs, you can experience wild swings in a limited amount of time. Therefore, dollar cost averaging would be recommended
- If you are going to invest in bonds or other "safer" assets, you can go with the lump sum approach and the timing risk will be relatively limited
Beyond common wisdom, the other source of advise I found is a study by Vanguard published in 2012 - you can find it here. In the study, the authors simulated a DCA vs Lump Sum strategy in 3 different countries (USA, UK, Australia) and checked for the returns after 10 years. The baseline case for DCA is that the full amount is invested within one year, so nine years are left for the full amount to provide returns.
The simulations use historical returns and can start in any month & year combination that provides a 10 year long history (e.g. January 1926 to December 1935).
The results show that a lump sum strategy delivers in around two third of the cases higher returns than DCA. On this timescale, having invested earlier seems to be paying off. That said, the difference between the 2 scenarios is on average not that big - 2.3% at the end of 10 years - meaning that if DCA would have returned 1,000,000 Euro, the Lump sum approach would have returned 23,000 Euro more.
That said, if the concern is not the average outcome but the avoidance of a bad one, DCA takes the lead. In fact, lump sum investing would have returned a decline at the end of the timeframe in 22.4% of the cases, while DCA only in 17.6%. Moreover, the average loss during these negative performance periods was higher for the lump sum investing than for DCA.
There you have it! If you invest in relatively safe asset classes, go for lump sum. For riskier asset types, if you dont feel comfortable with a lump sum approach, maybe you can try dollar cost averaging over a shorter time frame (e.g. 6 months vs 12 months) than what you had in mind.
Dont overthink it too much, anyway the difference over the long term does not seem to be that big!
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