if you're sitting on a lump sum of cash that
you plan to invest
you could invest the lump sum in a risk
appropriate portfolio immediately
you could dollar cost average over a period of time
meaning systematically investing equal parts
into a risk appropriate portfolio over a set period
or you could sit on
your cash until what feels like a good time to invest
this is a decision that I know torments people
when they have cash available
cash feels safe
and the stock market feels scary
there's always a reason
whether it's market valuations
world events
or economic news
that makes the current moment in time feel like
the scariest time ever to invest
I'm Ben Felix
Portfolio Manager at PWL Capital
and I'm going to tell you
how to decide between dollar cost averaging
and lump sum investing
I wanna be clear before starting that
I'm assuming that you have a lump sum to invest
if you're saving regular amounts from your paycheck
there is no decision to make. You are dollar cost averaging
by necessity
if you have a lump sum available
you need to decide how to enter the market
dollar cost averaging feels smart
the reason often given for its apparent
effectiveness is that when stock prices are high
you're buying fewer shares
and when prices are low
you're buying more shares
while mathematically correct
dollar cost averaging has been proven objectively
sub optimal many times
the strongest argument in favor of dollar cost
averaging is behavioral
behavioral economist Meir Statman
offers a framework in a 1995 paper to explain
why dollar cost averaging remains popular
despite being sub optimal in short
dollar cost averaging can help with minimizing regret
avoiding investing a lump sum right before a crash
by instead making lots of smaller investments
despite the behavioral appeal
I think it's useful to understand how
sub optimal dollar cost averaging is
relative to lump sum investing
this doesn't mean that data
are more important than investor behavior
but I think it is important to make
decisions from a perspective of understanding
rather than a perspective of fear
in a 2020 analysis
we compared lumpsome investing to dollar cost
averaging in six stock markets
while the cash was being deployed in our model
it earned the rate of return
of one month US Treasury bills
across the full sample
investing a lump sum
beat dollar cost averaging about 65% of the time
the approximate annualized cost of dollar cost
averaging was about 0.38% over 10 years
much more than the fee on most index funds
whether regret minimization is worth that
estimated cost will be a personal decision
to try to address common concerns that come up when
people have a lump summit to invest
we also looked at the performance of dollar cost
averaging in a few specific cases
in the worst 10% of outcomes for lump sum investments
dollar cost averaging does have a small
advantage on average
but it still trails
lump sums more than 50% of the time
this is surprising
given that we were looking at the worst
periods for lump sums
with perfect hindsight
even if you knew for
certain it was a bad time to invest
which of course
nobody can predict
dollar cost averaging is not a silver bullet to improve
the outcome
if the decision to invest is being made immediately
after a 20% or greater drop in the market
a time when behavioral biases are likely heightened
lump sums continue to be advantageous on average
finally we compared investing a lump sum to dollar cost
averaging when US stock
valuations were in the 95th percentile of expensiveness
and found again that lump sum continues to dominate
these findings are far from revolutionary
a long list of academic papers going back to the 1970s
have suggested that dollar cost averaging is
sub optimal in a rational decision making framework
even if dollar cost averaging is
deemed useful from a behavioral perspective
I have to question whether the portfolio being deployed
in that case is just too risky for the investor
a 2016 paper in the Journal of Wealth
Management demonstrates theoretically
numerically
and empirically that dollar cost averaging is
approximately equivalent to an asset allocation
where only 50 to 65% of
the portfolio is invested in risky assets
and the rest is invested in riskless assets
but that dollar cost averaging is sub optimal
compared with a portfolio with a constant 50 to 65%
risky allocation
the authors conclude that dollar cost averaging
should be recommended with care
since risk averse
investors could be better off investing a lump
sum in a more conservative asset allocation
instead of dollar cost averaging
into a more aggressive one
rather than investing a lump sum
or dollar cost averaging
many investors
opt to wait for a drop in the level of market prices
before investing
they opt to buy the dip
in a separate analysis
we looked at waiting
for a 10 or 20% market decline to invest a lump sum
and found that buying the dip underperforms on average
and in most ten year periods
in our sample
waiting for a 20% drop gives up more return
and underperformed more frequently than waiting
for a 10% drop
this even holds true when
the analysis is constrained to starting
months that are all time highs in the market
if you have a lump sum to invest
it is likely optimal to invest it in a risk
appropriate portfolio as soon as possible
there is a strong behavioral argument
for dollar cost averaging though
if you're so worried about regretting
the decision to invest a lump sum
that you deem dollar cost averaging necessary
it might be a sign to reconsider your asset allocation
thanks for watching
I'm Ben Felix
portfolio manager at P
W L Capital
if you enjoyed this video
please share it with someone who is struggling to
decide how to invest a lump sum of cash