By Yashovardhan Sharma
If you've come into a substantial sum of cash, whether through the sale of a business, a mature investment, a significant bonus, or a sizable inheritance, you might be contemplating how best to invest a portion of it to align with your long-term financial objectives. However, the decision-making process becomes intricate when determining the optimal strategy for deploying this new capital in your investment portfolio. Questions arise, such as whether to invest the entire amount at once or gradually, and whether to initiate the investment immediately or wait for a more favorable market outlook. Given the common aversion to losses among investors, the prospect of making decisions about the precise method and timing of investments can lead to a state of paralysis. This predicament is particularly pronounced in today's uncertain market landscape.
Despite the positive momentum fueled by expectations of Federal Reserve interest-rate cuts and enthusiasm surrounding advancements in artificial intelligence, U.S. stocks have experienced robust gains in 2023, recovering a substantial portion of their significant losses from 2022. This resurgence has enticed many investors to participate in the ongoing rally. However, Morgan Stanley's strategists foresee economic challenges and anticipate a slowdown in corporate earnings growth, which could potentially trigger renewed market volatility. Given these circumstances, it might be more prudent than usual to explore dollar-cost averaging as an alternative to the conventional lump-sum investing approach. Here, we delve into the advantages and disadvantages of both strategies.
Dollar-cost averaging involves systematically micro-investing your funds in equal increments over a specific period, such as distributing $2440,000 in monthly installments of $20,000 over a 12-month span.
Advantages: This method of gradually contributing to your portfolio proves beneficial for those who approach the market cautiously. Distributing investments over time at varying share prices reduces the impact of a single trade date on your portfolio's overall return. This mitigates the risk associated with investing a lump sum just before a significant market decline. For instance, if the initial installment coincides with a sharp drop in share prices, any loss incurred is limited to the portion already invested, rather than the entire intended investment amount. This strategy fosters commitment even in the face of initial poor returns and can help navigate market fluctuations during times of volatility, allowing you to adhere to your long-term goals without feeling compelled to alter your underlying investment strategy.
Disadvantages: However, the approach of investing smaller amounts incrementally may result in missing out on potential positive returns in a bullish market.
Lump-sum investing involves putting all your capital into a diversified portfolio at once.
Advantages: This method allows for immediate deployment of your capital, often proving advantageous over extended periods. In an analysis encompassing over 1,000 historical seven-year periods, Morgan Stanley Wealth Management's Global Investment Office discovered that lump-sum investing generated slightly higher annualized returns than dollar-cost averaging in more than 55% of cases. For instance, in an "aggressive" portfolio with significant stock allocations, the lump-sum approach would have yielded a 0.41% higher return than dollar-cost averaging over a 12-month period. Similar results emerged from over 10,000 forward-looking hypothetical simulations using both approaches, with lump-sum investing becoming more attractive relative to dollar-cost averaging as the portfolio's expected returns exceeded those of cash.
Disadvantages: However, predicting short-term market movements is challenging. Investing all your money at once, especially during a volatile period in stock market cycles like the onset of a correction or a bear market, may result in significant losses that could take years to recover. This can have both psychological and financial ramifications, as individuals may draw incorrect conclusions from substantial losses, compounding the setback by underinvesting in markets relative to what is needed to achieve their financial goals.
Similar to any risk-reducing investment strategy, such as investing in bonds, dollar-cost averaging comes with drawbacks. Essentially, a dollar-cost averaging investor may miss significant market fluctuations because they hold back their funds for the next scheduled deposit into the investment. By the time the funds are ready for investment, the market may have already self-corrected, resulting in missed gains. A study conducted by finance professors Richard E. Williams and Peter W. Bacon in the early 1990s analyzed approximately 70 years of historical stock market data. Their findings revealed that about 67% of the time, an investor who opted for a lump-sum investment experienced higher returns in the first year compared to someone employing dollar-cost averaging and incrementally investing throughout the year.
A more recent study by Vanguard compared dollar-cost averaging and lump-sum investing in a 60/40 (stock/bond) portfolio across three different countries. In each market, they observed that a lump-sum investment led to greater portfolio values roughly two-thirds of the time. Various iterations of the test produced very similar results. Finally, a study conducted by Robert Atra and Thomas Mann in 2001, published in the Journal of Financial Planning, asserted that "The results (of various studies) suggest that DCA is neither as effective as the personal finance literature claims, nor as suboptimal as the academic literature claims." In essence, from a statistical standpoint, dollar-cost averaging may not live up to its perceived benefits. While it provides a certain level of safety and peace of mind, it comes at the expense of potentially higher returns.
While each strategy, lump-sum investing, and dollar-cost averaging, comes with its advantages and disadvantages, refraining from investing altogether due to fear of making a wrong decision may be the least advisable course of action. This approach places too little emphasis on providing your savings with the opportunity to potentially grow. Instead of getting bogged down by overthinking the timing and method of entering the market, it is generally more prudent to commit to an investment plan that aligns with your financial goals and facilitates wealth accumulation over timewhether through lump-sum investing or dollar-cost averaging. Your Morgan Stanley Financial Advisor can assist you in formulating a goals-based strategy, evaluating current market risks and opportunities, and guiding you to determine the approach that best suits your circumstances.