Dollar Cost Averaging vs. Lump Sum Investing Backtest – Sequence Of Return Risk (Luck, Skill, Or Magic?)
Last Updated on October 24, 2022
Most investors and traders are aware of the differences between dollar-cost averaging vs lump sum investing. But what role do luck and randomness play in determining the best strategy – dollar-cost averaging or lump sum investing? In this article, we dig a bit deeper and turn the returns over the last twenty years upside down to look at the sequence of return risks via backtests.
This article defines the difference between dollar-cost averaging and lump-sum investing. We explain what it is, why lump-sum investing is the best option, and finally, we look at how dollar-cost averaging is exposed to sequence of return risks. As our backtests prove in this article, you might underperform massively by dollar-cost averaging if you are “unlucky” with your timing and sequence of returns.
Investing in stocks for the long-term has produced excellent returns over the last 120 years. We are told to save, invest, and forget about it. Unfortunately, few of us live for 120 years and we are thus prone to the sentiment of Mr. Market in the “short-term”. In a time span of 120 years, we would consider 20 years as “short-term”. To smooth returns and not be a victim of Mr-Market’s mood swings, many suggest using dollar-cost averaging.
Why invest for the long-term?
This website is mainly about short-term trading, but we also like to invest in stocks and mutual funds for the long term. We believe every trader should invest a portion of their assets outside their trading. This is done to mitigate and reduce the risk of adverse short-term blunders. You need to be diversified in terms of time frame.
How do you allocate your long-term capital?
You can invest all your capital at once (lump sum) or you can invest gradually. The latter is called dollar-cost averaging:
What is dollar-cost averaging (DCA)?
It’s an investing strategy where you invest a sum of money via many installments spread out in time. This is the opposite of a lump-sum investment done once or just a few times.
Dollar-cost averaging is thus a strategic investment over time. For example, you might invest 250 USD at the end of every month, 12 times per year. You might do this for 10 years and you are spreading out your investment at different price levels.
Lump-sum investing involves investing in the markets at the earliest opportunity. As long as the markets go up, lump-sum investments should make you more money in the long run.
Dollar-cost average vs scale-in
Dollar-cost averaging and scale-in are essentially the same. The principle of them both is to don’t invest all the capital at the same time, but to scale-in gradually.
We have made an example of a scale-in strategy.
Why dollar-cost average?
Studies show that a lump-sum investment today comes out ahead of dollar-cost averaging most of the time. In a study by Morningstar in September 2020 (When Dollar-Cost Averaging Can Help) the conclusion was that DCA investors beat lump-sum investors 27.8% of the time for 10-month periods. If we look at 10-year periods the number is only 10%.
Morningstar’s conclusion makes sense. If stocks go up in the long run, obviously it makes sense to invest as early as possible to have your money work for you. Keeping money idle on the sidelines is, in general, not a good idea, certainly not for years. Additionally, inflation is also eroding your capital gradually.
However, there are many reasons to dollar-cost average:
- Most people simply don’t have the “lump-sum” capital available right now for many reasons. They invest as they earn money through their salary. This is no stress and most do this via automatic payments. No fear is involved.
- Investing involves fear of losing money. Those who have capital available might spread their investments in time to avoid investing at the top. This might help people to invest, otherwise, they might not invest at all. The fact is, many investors would simply not invest at all if they couldn’t dollar-cost average.
The (sad) fact is that most retail investors fail to beat the main averages. As a matter of fact, most lag by a lot.
Why do private investors fail to beat the averages?
First, not all can beat the averages, that is an impossibility. The market is a zero-sum game measured against the averages.
Second, a lot of money gets “drained” out from the market in commissions, fees, slippage, and other costs. The only ones making consistent profits are brokers, investment bankers, and consultants.
However, the main reason why most fail is that they are prone to behavioral and trading biases. For example, this could be selling after a big fall then returning to the market to reenter when it has risen and it’s “safe” to buy again.
Peter Lynch and his Magellan fund experienced annual returns of 29% for 13 years, but still, many investors managed to lose money. They buy on the top, after a steep rise, and sell after a drop when they become fearful.
Lynch pointed out the fact that dollar-cost averaging once a year in January from 1975 to 2000 gave an annual return of 11%. If you invested at the highest price per year, the returns only fell to 10.6%. If you invested on the bottom every year, the returns increased slightly to 11.7%.
Dollar-cost averaging removes a lot of fear from your decisions. Precisely because of this many should do it like this instead of trying to time the market.
Investing and alternative histories
In Fooled By Randomness Nassim Nicholas Taleb wrote about alternative histories. These are the paths or ways that didn’t take place, but it could equally well have happened due to chance, luck, and randomness. The famous “disciple” of Taleb, Mark Spitznagel, has also explained alternative histories weel in his book called Safe Haven Investing.
This article simulates DCA by switching the order of S&P 500’s return from 2000 until 2020.
This could also be called sequence risk:
Dollar-cost averaging vs lump sum investing: sequence of returns risk
We have in numerous articles recently explained what this is. Let’s give you one example: assume you started dollar-cost averaging in January 2000 until 2020. The first ten years were sideways, but the last ten years were mostly a steady drift up. What would have happened if it was the opposite, ie, the first ten years were bullish and the last ten years were sideways with a lot of choppy markets?
This is what you’ll find out today in the backtests below:
A backtest of dollar-cost averaging
This section is threefold:
- We show the performance of a lump-sum investment, and
- We show how dollar-cost averaging perform compared to a lump-sum investment, and
- How the sequence of return risk might influence your end result if you dollar-cost average.
In all the examples, we start with 60 000 in January 2000 and we end in December 2019. The index is the S&P 500.
Example one: a lump sum investment
We invest 60 000 on the first day of January in 2000. By 31st of December 2019, the equity has grown to 193 157 USD:
It was a bumpy ride and the worst drawdown in 2008 was a gut-wrenching 55%. The CAGR is the same as buy and hold, obviously: 6.02%.
What if we instead invest those 60 000 by dollar-cost averaging?
Example two: dollar-cost averaging from 2000 until 2019
We invest 250 USD on the first day of a new month and continue all the way up until December 2019. This equals 60 000 invested in both good and bad times, but we would have idle cash at the start that only gradually were invested.
The equity chart looks like this:
Despite having a decreasing cash position all the time until 2019 the CAGR is only slightly lower than the lump-sum/buy and hold: 5.5% (buy and hold is 6.02%). The reason is that we kept on investing through the bad times in 2001-2003 and during the financial crisis in 2008/09.
As we all know, the stock market moved nowhere from 2000 until 2010 for so to take off and rise spectacularly. What if it was the other way around?
We make a third example:
Example three: we reshuffle the sequence of returns
We simply take the performance from 2010 until 2019 and place those returns before the performance of 2000 – 2010. The sequence is hence changed.
How does this influence the results? Pretty much.
The lump-sum investment would look like this (this is the buy and hold):
The CAGR drops from 6.02 down to 5.93%. The end result is more or less the same.
What happens to dollar-cost averaging?
The dollar-cost averaging has the following equity curve after the reshuffle:
The change in the sequence of returns has a devastating effect on the end result: it falls from 173 949 down to only 87 396. CAGR drops from 5.5% to 1.9%! That would be devastating if you were about to retire.
The reason for the poor performance is, of course, because the market rose in the first half (while you had much cash) and went nowhere in the second half when you had more invested.
Amibroker code for dollar-cost averaging backtesting
If you’d like to have the code in Amibroker for dollar-cost averaging, you can buy it on the link below. Additionally, you get the code and logic behind all our free trading strategies (we are continually updating Tradestation and Easy Language code as well).
Amibroker is a very powerful tool despite its cheap price. It works both for backtesting and live trading, especially with Interactive Brokers. How you can learn to code, do backtests, and live trading is described in our Amibroker course.
Dollar-cost averaging vs lump sum investing – conclusion
Our dive into dollar-cost averaging vs lump sum investing indicates that lump-sum investing is the best option. We believe that randomness is more likely to influence the result of your dollar-cost averaging than you think. The sequence of returns matters. We tend to be influenced by recency bias and we forget that the market changes all the time. It doesn’t go up all the time. If you invest for the long term, invest when you have spare capital.