Dollar Cost Averaging vs. Lump Sum Strategy Backtest – Managing Sequence of Return Risk

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 a dollar-cost averaging (DCA) strategy?

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