Dollar Cost Averaging vs Lump Sum: How to Invest A Large Windfall

So you have a large sum of money that you’re thinking of investing into the markets. Great decision, that’s how anyone and everyone builds wealth in today’s world! The question is, do you dump that amount of money all at once into the market, or take a slower approach by slowly dollar cost averaging (DCA) into the markets? That is the timeless question that’s been asked on every forum and Subreddit since the dawn of capitalism.

As someone that is very active in investing and has already achieved financial independence, this is the age old question when I had large windfalls to invest. The purpose of this post will be to hopefully answer this question and which option you should go with.

What is Dollar Cost Averaging?

Dollar Cost Averaging is an investment strategy where an investor divides the total amount to be invested across periodic purchases of a target asset. This approach reduces the impact of volatility on the overall purchase. The purchases occur regardless of the asset’s price, thus averaging the cost over time.

How Does Dollar Cost Averaging Work?

Imagine you want to invest $1,200 in a particular stock over the next year. Instead of investing the entire amount at once, you would invest $100 each month. If the stock price is high one month, you purchase fewer shares. If the stock price is low the next month, you buy more shares. Over time, this method averages out the purchase price of your shares.

Example:

• January: Stock price = $10, you buy 10 shares
• February: Stock price = $12, you buy 8.33 shares
• March: Stock price = $8, you buy 12.5 shares

By the end of three months, you have invested $300 and own approximately 30.83 shares at an average price of $9.73 per share.

Benefits of Dollar Cost Averaging

1. Reduces Market Timing Risk

One of the biggest challenges for investors is timing the market. DCA mitigates this by spreading investments over time, which can help smooth out the effects of market volatility.

2. Encourages Disciplined Investing

DCA promotes regular investing habits, which can be particularly beneficial for new investors. By committing to invest a fixed amount regularly, you avoid emotional investing based on market highs and lows.

3. Takes Advantage of Market Downturns

When the market drops, the fixed investment amount buys more shares, reducing the average cost per share. This can potentially enhance returns when the market rebounds.

When Should You Use Dollar Cost Averaging?

While DCA is a useful strategy, it’s not always the best choice for every investment scenario. Here are a few situations where DCA might be advantageous:

• Volatile Markets: If the market is experiencing high volatility, DCA can help mitigate the risk of buying at a peak.
• Long-Term Investments: For long-term goals like retirement, DCA helps build wealth gradually and reduces the impact of short-term market movements. This doesn’t really answer the question for those looking to invest a big lump sum however.
• New Investors: If you’re new to investing, DCA can help ease you into the market without the pressure of making large, lump-sum investments.

What is lump sum investing?

Lump sum investing is essentially investing everything in one go. Let’s say you have $100,000 in cash. You might have obtained this through inheritance, YOLO’ing options, or just saving it through many years and never having invested it (shame on you). How you got there doesn’t matter for this post, but rather how you will deploy it into the markets.

Lump sum investing is the ethos of the most famous investing quote:

It’s been proven time and time again that over the long run, lump sum investing is the best approach. Sure you could get very lucky and time the markets correctly but you also run the risk of timing the markets incorrectly. For 99% of us, the best approach is to just dump your entire sum into the markets in one go.

How much is a large lump sum amount for it to matter?

Given I have a portfolio of almost $2m as of June 2024, I would consider anything 5% of my total net worth and higher to be the threshold where I would think about DCA vs lump sum investing.

Everyone’s threshold is different so by no means use mine to benchmark what is comfortable for you.

When does DCA beat Lump sum investing?

Lump sum investing works because the general trend of broad market ETFs like the S&P 500 or the Nasdaq have always trended upwards in their entire existence. If this was not the case and let’s say the price action was more sideways, then lump sum investing may not beat DCA. Keyword is may.

Of course, this is one example where the timing was perfect and DCA outperformed lump sum investing. However, unless you’re relying on luck or know something no one else does, it’s unlikely you’ll win in this strategy long term.

Why does lump sum beat DCA?

Now it’s time to talk about why lump summing is almost always better than DCA. The chart below created by Ycharts over a 25y period shows just effective lump summing is vs 24 months of DCA. In almost all instances.

You can see that DCA has never outperformed lump sum investing after the financial crisis. We’ve had the mother of all bull markets since 2008 so this is one of the reasons why but are you going to be the one that calls a turnaround?

Dollar Cost Averaging strategies

There are countless ways to dollar cost average your portfolio. Whether you plan to invest daily, weekly, monthly, or yearly, you have the freedom to choose anything. Some methods are even more sophisticated like buying a smaller amount on a green day, and buying larger amounts on a red day.

For the purpose of this study, I will run simulations over a 6y time period from 2015 to 2021 on TQQQ. This triple leveraged Nasdaq ETF is something I hold in my stocks portfolio.

The 4 scenarios I will backtest are the following:

The 4th and final scenario will be one where I buy the stock daily based on certain parameters centered around buying the dip.

The results are as follows:

In the results, it’s the yearly scenario that won out. Lump summing everything at the beginning of the year turned out to be better than investing every week or every month or my daily buy the dip scenario. The graph below depicts the different scenarios:

Of course this is just one simulation over a specific time frame. We could choose any other time frame and you’ll probably come out with different results.

What if we bought the entire amount in 2015?

The above scenarios show how to DCA an amount of $165,000 over the course of 6 years into the market from 2015 to 2021. Of course, most people do not have $165,000 just laying around and most people will save this amount by working the old fashioned way.

What if you did have $165,000 as a lump sum however? That is the whole purpose of this post after all. The calculation would be pretty simple.

You would start off 2015 by buying about 20,000 shares of TQQQ as the price on Jan 2, 2015 was about $8. At the end of 2020, the price was $90 which means you your portfolio would have increased by an absurd $1.6m!

With that said, it’s clear that you should never DCA over an extended period of time and lump sum is clearly a winner.

Dollar cost averaging and the mental side of it

Dollar cost averaging is a very popular method for those looking to invest and build out their portfolio. However, is it the most effective way to deploy a large sum of money? That is the question.

I find that with DCA, a lot of it is mental. When you come across a large sum of money, your natural instinct is one of caution and conservatism.

“What if the markets crash?”

“Am I buying at the highs?”

“Markets are overvalued.”

These are the common things people think of, even if they know that it is probably better to just lump sum a large amount of money into the markets. I’m guilty as charged. I always have these thoughts when I want to invest a large sum of money into the markets. Most of the times, I end up just dumping the whole amount into the markets but there are other times where I just can’t bring myself to do it.

That’s where DCA I think comes into the fold. As we’ve already proved, it does not beat lump sum investing in most situations, yet we still do it. Thankfully, if you DCA into your investments in a shorter period of time (6mo and below), your returns are generally not too far off from lump sum in most instances.

If it makes you sleep at night knowing you are slowly dumping your money into the market, then just do it so you have the mental security. Sometimes a little sacrifice in long term ROI is worth it for better sleep! We are human after all and we can’t control our fears or emotions at times!

How to Dollar cost average if you must?

Now that we have touched upon the mental side of DCA, how should you DCA if you must do it?

As I’ve mentioned before, if you DCA over a long period of time, let’s say 10 years, you will almost always underperform versus lump sum investing. This is just common sense.

S&P 500 has returned something like 8-9% over the last century so you are foregoing that ROI every year by whatever interval you’re investing in.

Pick a time frame and strategy you’re comfortable with

As you’ve seen with strategies above, there’s no one stop shop for a DCA strategy. Most brokerages will let you auto invest from your cash balance depending on the time frame you want so it’s easy to just set it and forget it.

If I want to DCA over 1-2 years, I would probably buy every month (let’s just say the 1st of every month). If I’m DCA’ing over 3-6 months, then perhaps I would do it once a week. I don’t think there’s any benefit for one strategy over the other but in the end of the day, the main objective is to just get my money into the markets invested.

Stick to the plan and don’t deviate

Once you have your time frame and amounts figured out, stick to the plan. Do not have a relapse and decide to do something different. If the markets do crash in that time frame, consider it a blessing that you’re buying in at a cheaper price. The worst thing you could do is to stop your DCA strategy only for the markets to shoot back up.

Treat this as if you were going to the gym. The most important aspect of working out is staying consistent and not letting anything distract you from the prize. Treat DCA investing in the same light!

Summing it all up

Now that you have seen the pros and cons of DCA vs lump sum, what is the best strategy for you? Historically, it’s almost always better to lump sum invest into an investment that is consistently rising like the broader market ETFs. You’re investing with a long time horizon anyway so the earlier you start investing the better.

However, if you come across a huge sum of money, you may feel mentally strained dumping it all in one go. You have some sort of attachment to that money which makes sense. If you can’t stomach dumping it into the market all at once whether it’s because the markets are at all time highs, or you are expecting a crash, then DCA might be for you. I would DCA over the course of 1 year at a maximum. Bear markets generally don’t last for more than a year anyway!