Mastering Dollar Cost Averaging: The Strategic Path to Investing Your Windfall

The United States is experiencing an unprecedented transfer of wealth, with estimates suggesting that over $70 trillion¹ will change hands in the next 25 years. This monumental shift means that many individuals may suddenly find themselves managing a significant financial inheritance. Coupled with life's unpredictable yet fortunate occurrences like receiving a substantial work bonus or winning the lottery, the responsibility of such wealth can be as daunting as it is fortuitous.

Whether through inheritance, a sizable bonus, or the stroke of luck in a lottery, the crucial question remains: How should one invest this windfall? This blog will illuminate how Dollar Cost Averaging works, why it's especially pertinent during a generational wealth transfer, and how it compares with other investment approaches for investing a windfall.

Dollar Cost Averaging Demystified

At its core, Dollar Cost Averaging (DCA) is a strategic approach to mitigating risks when purchasing stocks or exchange-traded funds (ETFs). It involves buying smaller amounts at regular intervals, no matter the price, rather than investing a large amount at once. This strategy avoids the pitfalls of trying to predict the perfect entry point in the market.

Attempting to time the market is a dangerous game that often leads to suboptimal investment results. Historical data show that even the most astute investors shy away from market timing due to its complexity and unpredictability. In fact, the best market days frequently occur during overall bad markets, further complicating timing strategies.

The Pitfalls of Market Timing

Source: https://www.visualcapitalist.com/chart-timing-the-market/.

The Mutual Fund Conundrum

The question of what to do with a large lump sum of money is further complicated when an investor considers investing in mutual funds. For mutual funds, the advertised average return is based on the premise of investing a lump sum and leaving it untouched. However, average investors tend to move money in and out at inopportune times—buying high and selling low—which means they rarely achieve the advertised returns. The disparity between a fund's average return and the actual returns investors receive is known as the "Return Gap."

Mind the Gap

Average return gaps, by asset grouping

Source: *Return Gap is the difference between the average return for a fund and what the average investor actually experiences in returns within that fund (asset weighted returns in the fund).

Note: Down years are years in which the S&P 500 fell in value (2015, 2018, 2022) and up years are those in which the S&P 500 went up in value. High volatility years represent those where the realized volatility of the S&P 500 was 15% or higher over the year, and low volatility years represents all other years.

Source: Derek Horstmeyer, George Mason University.

To Lump or to Average? That is the Question

When it comes to making the most of a substantial financial gain, investors are often caught in a dilemma between investing all at once or distributing their investment over time. Let's delve into each strategy with real-world scenarios to better understand the implications of each choice.

Lump-Sum Investment: The Immediate Dive

Imagine you've just inherited $100,000. With a lump-sum investment, you would take the entire amount and invest it directly into the market. The primary benefit here is the potential for immediate growth; your money is fully exposed to the market's ups and downs from day one. For instance, if you had invested in a broad market index fund in early 2009, your investment would have significantly benefited from the long bull market that followed.

However, this strategy is not without its risks—if the market takes a downturn shortly after investing, your entire sum suffers the impact. Research by Morgan Stanley found that despite these risks, a lump-sum approach did yield a slightly higher return than dollar-cost averaging in a majority of historical seven-year periods.

Dollar Cost Averaging: The Measured Approach

Conversely, Dollar Cost Averaging (DCA) would mean taking that same $100,000 and investing it in smaller, regular installments—say, $8,333 every month for 12 months. This method can reduce the risk of market volatility because you buy more shares when prices are low and fewer when prices are high, which can potentially lower the average cost per share over time.

Let's look at an example. Suppose you started investing in January 2020, right before the market downturn due to the COVID-19 pandemic. A lump-sum investment just before the crash would have seen a sharp decline in value. In contrast, with DCA, you would have bought shares at lower prices as the market dipped, setting the stage for better gains as the market recovered.

The Hybrid Strategy: Combining the Best of Both Worlds

Then there's the middle ground—a hybrid strategy. Let's say you decide to invest $50,000 of your inheritance right away and then distribute the remaining $50,000 monthly over the next year. This tactic allows you to take advantage of immediate market opportunities with half of your funds while mitigating risk with the other half through DCA.

For example, if the market is bullish when you receive your windfall, your immediate investment allows you to capture some of that growth. Meanwhile, if the market later experiences volatility, your DCA installments could acquire shares at lower prices, potentially reducing the average cost per share of your total investment.

In essence, the hybrid strategy aims to balance the benefit of 'time in the market' with the protective measures against the short-term volatility of the market. It's a tailored approach that caters to those who want to hedge their bets without missing out on the growth a bull market can offer or the purchasing opportunities presented in a downturn.

Navigating Investment Choices

Each strategy, be it lump-sum investing, dollar-cost averaging, or a hybrid of both, comes with its own set of advantages and disadvantages. The key is not to let fear dictate keeping money on the sidelines. Instead, it's about aligning with your client's investment goals, time horizon, and risk profile, setting a clear plan, and focusing less on market timing and more on long-term goals.