As an undergraduate majoring in Human Biology at Stanford, I was fortunate to study under the wonderfully entertaining anthropologist-biologist Bill Durham, who lectured us on competing theories of evolution.
He first described the long-dominant idea of gradualism, where minor adaptations accrue subtly over millennia to create slow, constant and consistent evolutionary changes over time. This idea was contested by supporters of punctuated equilibrium (notably Stephen J. Gould): sudden, major jolts to the environment favored certain adaptive traits, leading species to evolve over very few generations in response to severe, episodic stressors. As Bill memorably summed up the acrimonious feud among scientists, “It’s evolution by creeps versus evolution by jerks.”
This terminology came to mind over the summer when a friend in finance, waiting for a dip in the market that had not yet materialized, asked if I had thoughts about how to deploy a decent chunk of cash he’d kept growing on the sidelines for several years. His great fear, he explained, was that the market would drop immediately after he invested his cash. He knew himself well enough to acknowledge a short-term loss would cause him anxiety, even though he understood that rationally he ought to be in the market.
So what should my friend, an otherwise savvy finance type, pursue? Lump sum investing (invest the full amount immediately), or spreading out his risk via dollar cost averaging (divide the sum by x and make periodic investments over x intervals)? Which strategy is most likely to perform better over the long run? Which will let him sleep restfully at night? Let’s see what the gurus say.
First, our friends at Vanguard have studied this issue in depth and concluded that historically, lump sum investing yields superior outcomes two thirds of the time compared to dollar cost averaging. The benefits of investing everything immediately (which permit more time for compound interest to work it’s magic) overcome the drawbacks of entering the market just prior to a correction. Since markets go up more frequently than they go down, the net effect is the early investor gets the worm. This is the purely mathematical argument: trust your head over your heart.
Famed Boglehead Rick Ferri takes a nuanced approach. Where the windfall constitutes <20% of your savings, he advises lump sum investing since pain from a correction will not affect the bulk of your portfolio. He additionally considers the source of the money to determine whether it should be deployed immediately. For example, if the windfall comes from a liquidated pension plan, then treat it as previously invested money and pop it back into the market: from risk it cometh, and to risk it shall return. Finally, he notes situations where a hybrid approach might be called for: he recommends investing a million dollar after tax lottery winning as a 400k lump sum with three subsequent 200k quarterly investments for the remainder. His philosophy might be summarized as if you can’t outright follow your head, then use your head to protect your heart.
Larry Swedroe, another respected Boglehead, advises a sort of jedi mind trick with abbreviated periods of dollar cost averaging. If the market drops after your initial investment, you pat yourself on the back for holding out the remainder to get a better deal. If it rises, you congratulate yourself on having invested and already made a profit. He’s more about helping you feel good regardless of outcome to avoid sitting on the sidelines, which he views as the only losing strategy. His approach might be described as fool your heart into following your head.
Looking to Bill Bernstein’s old posts (written in cuneiform font from back when the internet was newly invented by Al Gore), we find this guest post by a math professor supporting 12 months as the optimal period over which to dollar cost average, so that you limit your downside without completely sacrificing your upside based on historical performance. His is the technical engineer’s approach: use your head to relentlessly optimize.
Big ERN at Early Retirement Now recently posted a slick hack he devised to utilize leverage as a means of reducing the opportunity cost of dollar cost averaging without sacrificing risk reduction. While it’s likely only appropriate for a select few advanced number-loving students of finance, I have to give him credit for a unique new insight on what most considered a tired subject. His is the financial engineer’s approach: check out this new loophole my head discovered!
For the final word on this matter, I refer you to the definitive and masterful Bogleheads post by stlutz, who will leave you wetting yourself in the good way (without advanced dementia in a nursing home).