Why Dollar-Cost Averaging Outperforms Lump-Sum Investing

Learn the benefits and myths of dollar-cost averaging, how it’s unfairly criticized versus lump-sum investing, and why volatility is a benefit, not a risk.

For decades, financial experts have told us that dollar-cost averaging (DCA) is a safe and effective long-term investment strategy. Yet, occasionally, I’ll run across an article critical of DCA (example, example, example). These articles purport to demonstrate that lump-sum investing is superior to dollar-cost averaging. However, as I will explore below, even though their logic is correct, their conclusions are misleading (or at least incomplete). In fact, their critique of DCA is actually an endorsement of it when explained using the proper context.

The first step in untangling this debate is to differentiate the two common meanings of dollar-cost averaging.

Dollar-Cost Averaging as a General Strategy

The first usage of DCA is relative to how most people invest. You contribute a (roughly) fixed amount of money on a regular schedule (e.g. monthly, quarterly, annually, or every paycheque) into a predetermined asset.

This strategy has several benefits:

1. It creates the habit of investing—you say, “Every month, I invest $X into Y”.
2. It removes the emotions from the decision-making in the moment. You’ve already decided what to do ahead of time—which avoids the risk of trying (and likely failing) to time the market.
3. It eliminates the timing concern when first investing (are markets about to fall?). With DCA, now is always a good time to buy—today’s price is unimportant.

In essence, DCA is a proactive investment strategy which aims to minimize discretionary (and probably unwise) decisions driven by emotions. You regularly set aside money from your employment income to invest. It’s a natural and practical way to build your long-term savings. It may not be the optimal strategy, but it’s likely the best strategy for most people unless you have access to a crystal ball. The alternatives are reactionary—you try to time the market based on current conditions or pick investments based on current recommendations.

Dollar-Cost Averaging as Risk-Reduction Tactic

The second usage of DCA is in the context of a single contribution. For example, if you have $10K available now, should you invest it all today or spread it out into smaller purchases (e.g. over 12 months)?

The premise of delaying is that if you spread out your buying, you reduce your chances of buying just as the market is about to decline. The problem is that you also reduce your chances of buying just as the market is about to rise. While we (or the financial media) may have feelings or predictions about where the market is going in the near term, investing based on predictions about the market is unlikely to be profitable.

Fortunately, many experts have studied whether splitting your contributions is beneficial. Their research clearly shows that delaying your buying will usually be worse than investing it all now. The simple reason is that standard investment assets (i.e. stocks and bonds) trend up most of the time (roughly 75%) and that the opportunity cost of delaying outweighs the potential benefits of waiting (on average).

This logic is the core argument of DCA detractors. However, notice that their real point is not that DCA is inferior but that waiting has a cost. Their unstated assumption is that DCA always means delaying your buying. But what if instead of investing $10K now, you had invested $2.5K each of the previous 4 quarters (or $200 weekly)? Why assume we can’t leverage DCA to accelerate our buying instead of delaying it?

The real question is: why do you have $10K to invest today? You could have gotten it as a one-time bonus at work or another unplanned source. However, I suspect most people simply procrastinate (e.g. they don’t allocate money to pay themselves first) and only get around to contributing to their savings infrequently. For example, some people’s only retirement savings contribution is their annual income tax refund (which could have been available to invest sooner if they’d filed the proper tax forms with their employer to stop loaning their money to the government for the year).

The real point is to forget about lump-sum versus DCA for regular contributions. The lesson is to buy sooner rather than later, regardless of whether your contributions are equally sized. Don’t save up to make a lump-sum investment. Don’t delay your buying in the hopes of buying at a lower price.

True Lump-Sum Contributions

Most investors build their savings primarily using regular (or semi-regular) ongoing contributions. But what about a significant one-time contribution (e.g. >25% of your expected lifetime contributions)? For example, if you sell a property or business or receive a large inheritance. An abnormally large contribution is the unusual scenario that the lump-sum versus DCA debate was actually meant to address.

Remember that the historical evidence showing that waiting has a cost only applies on average. To be prudent, we must consider potential worst-case returns when making a disproportionately large contribution. Being unlucky and mistiming that single contribution could have a devastating effect on your returns.

Does using DCA in this scenario make sense? Often, yes. For example, consider the case of a long-term investor saving for retirement using a growth portfolio (as you should). Growth assets will be more volatile in the short term, leading to more timing risk for one-time contributions. So, if we contrast risk mitigation strategies, we can compare investing a lump-sum into the S&P 500 stock index ETF versus DCA into the same asset and a lump-sum into a less volatile investment (e.g. balanced 60/40 stock/bond portfolio).

DCA versus Lump-Sum Contribution

S&P 500 versus 60/40 portfolio, average 10-year return (1993–2023), DCA monthly over 12 months

As you can see, DCA performs worse than the lump-sum investment three-quarters of the time for the S&P 500 (as expected). However, it improves the worst-case returns while outperforming the less-volatile (and lower-returning) 60/40 portfolio most of the time. Is that a tradeoff you’d make? I would.

For regularly-sized contributions, timing risk is negligible and will even out over time—opportunity cost (waiting) is the more significant risk. For unusually large contributions, DCA is a helpful way to reduce timing risk without resorting to lower-return assets.

The Benefits of Volatility

Besides encouraging you to invest earlier, there is another, less frequently discussed benefit of DCA—it leverages average everyday volatility to increase your returns, including making money even when the price of your investments ends up flat.

To illustrate this idea, I’ll concoct a set of simple assets that have a very regular type of price movement:

• Asset A — price is always $10
• Asset B — price alternates between $11 and $9
• Asset C — price alternates between $13 and $7
• Asset D — price alternates between $15 and $5

Assume that we’re making ongoing contributions and that the final price of each asset is $10. Which asset is the best choice? Given that the average price we’ll pay for each is $10 and the final price will be $10, intuitively, you’d expect it wouldn’t make any difference—but it does.

The secret is that when the price is lower, you’re buying proportionally more than when the price is higher.

DCA Benefit of Volatility

Buy $100 of each asset per month.

Results After 10 Years

As you can see, the more significant the price volatility, the bigger the benefit. So, even when the rate of return of an asset is 0% (the start and end price are the same), it’s still possible to have meaningful gains via volatility over the long term.

Volatility In Practice

To demonstrate this volatility benefit with real-world assets, I’ll use the S&P 500 Index, NASDAQ 100 Index, and US Bond Index ETFs since inception. As a comparison, I’ll create a matching asset for each with no volatility but with the same annualized rate of return—as in, the start and end price of each pair of assets is the same. The difference is the zero-volatility asset’s price is a straight line “up and to the right”, just like most investors crave.

I’ll analyze different contribution intervals to show how much frequency matters. I’m assuming that in each scenario, we contribute the same amount per year, split into equal-sized contributions, buying at the end of each period. I’m reporting the average 5-year rolling return rather than the return since inception because otherwise, the results will be skewed because the zero-volatility assets are unfairly penalized when there’s a significant drawdown at the beginning (e.g. the 2001 dotcom crash for the NASDAQ) or unfairly helped if there’s a substantial drawdown at the end (e.g. the 2022 COVID crash for bonds):

Average 5-Year Rolling Return of Actual Asset versus Zero-Volatility Asset

S&P 500 Index (symbol SPY), 1994–2022

NASDAQ 100 Index (symbol QQQ), 2000–2022

US Bond Index (symbol AGG), 2004–2022

There are two interesting things to notice from these results. The first is that the more frequent (i.e. earlier) contributions generate higher returns (as expected from the opportunity cost of waiting). The second thing is that the natural volatility of these assets gives you a meaningful bump in your effective rate of return versus the zero-volatility version. This increase is correlated to the relative volatility of the asset, the same as I demonstrated in my previous example with the contrived assets. This hidden performance boost, above and beyond the advertised rate of return, is a nice additional bonus for using DCA with growth assets—adding a percent or two to your return can represent a significant amount of money over the long term.

Consider contributing at least quarterly when investing in stocks or mutual funds as a simple rule of thumb. If transaction costs aren’t relevant, investing more often will likely have additional incremental benefits. On average, buying more frequently and earlier will always perform better—contributing annually is probably not often enough. Bringing your contributions forward six months can also help compensate for less frequent contributions. For hyper-volatile assets, like crypto, I prefer weekly or daily purchases.

Key Points

• Dollar-cost averaging as a general strategy is when you buy a fixed dollar amount of a specific asset on a predetermined schedule—you’re building your investments using a disciplined, mechanical strategy.
• It’s not essential to contribute the same amount or on the same schedule—invest whatever money you have when you have it.
• Dollar-cost averaging is the ideal low-effort way for most investors to build their retirement savings—the alternative is timing or reacting to the market, which is unlikely to be effective.
• Buying more (rather than a fixed dollar amount) when prices are down is an even better way to increase your returns—but only for long-term investing (>10 years) in high-quality, safe investments (e.g. index funds or ETFs). Cheer when you can buy high-quality assets on sale.
• More volatile safe assets (e.g. stock indexes) become even more attractive over less volatile assets (like bonds) because DCA gives you an underappreciated increase in your return and widens the existing performance advantage.
• Quarterly or monthly are suitable target contribution frequencies for long-term savings. If you can contribute each paycheque, that’s even better.
• Don’t use DCA as a reason to split (delay) your purchases for regular contributions—contribute earlier and more often. Consider spreading (delaying) abnormally large contributions to reduce your timing risk.

Points to Ponder

• How often are you contributing to your investments? Would it be easy to increase the frequency? Or contribute earlier?
• As a long-term investor, are you needlessly avoiding investing in more volatile, safe assets (e.g. stock indexes)?

Related Concepts

• Why Aggressive Portfolios Are Usually Safer Than Conservative
• How to Time the Stock Market and When You Shouldn’t Bother
• Why Compound Interest Is the Secret to Growing Your Wealth
• Why Passively Managed, Low-Fee Index Funds Are Ideal Assets

If you have comments, questions, or constructive feedback, you can contact us by email at questions@essentialsofinvesting.com.