March 15, 2023
Imagine receiving a windfall due to an inheritance, bonus payment, or sale of a small business. How would you invest the cash? Would you immediately invest all of it as a lump sum? Or would you make a series of investments over time—a strategy known as cost averaging—to avoid the risk of investing the entire amount right before a market downturn?
A recent Vanguard research paper, Cost averaging: Invest now or temporarily hold your cash? explores these and other questions, including an analysis of the performance of cost averaging (CA) and lump-sum investing (LS) across markets, historical periods, and simulated return scenarios.
“We find that LS tends to outperform CA, highlighting how a cash allocation reflects the opportunity cost of lost risk premium,” said Megan Finlay, an investment strategist in Vanguard’s Enterprise Advice group, who coauthored the paper with Josef Zorn, a U.K.-based wealth planning research strategist in the group. “But for some risk-averse investors, a CA approach may be more suitable, because it reduces the risk of drawdown or even abandoning their investment plan altogether because they fear large losses.”
Using MSCI World Index returns for 1976–2022, Finlay and Zorn calculated that LS outperformed CA 68% of the time across global markets measured after one year. However, CA was still better than remaining completely in cash; it outperformed cash 69% of the time.
Notes: This figure is for illustrative purposes only and does not represent any particular investment. Outperformance is based on comparing wealth after a one-year investment horizon with a lump-sum strategy versus a three-month cost averaging split (splitting a lump sum into three equal parts and investing each one a month apart). The investment is assumed to be 100% equity, with no interest earned on any uninvested portion, and performance is measured on a rolling basis after one year. The cash-only strategy is approximated by the 3-month U.S. Treasury bill rate. Calculations are made using MSCI World Index returns for 1976–2022.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
The paper also examines the performance of LS and CA using a one-year investment horizon of a $100,000 initial investment across three portfolios: 100% equity, 60% stocks/40% bonds, and 40% stocks/60% bonds. In most historical market environments, investors would have been better off investing the lump sum.
“A key takeaway from the analysis is that the longer the CA horizon, the greater the opportunity costs incurred and the greater LS’s performance advantage over CA,” Finlay said.
The paper also compares the two strategies using 10,000 simulated-return scenarios that tested various types of portfolios and CA period lengths. Consistent with findings from the historical analysis, LS in most cases yielded greater wealth after one year, but also greater losses in some of the worst market environments.
Because not all investors aim purely to maximize their wealth, and because some might find value in taking a slower path to portfolio growth if it helps to avoid big losses, Finlay and Zorn tried to quantify a loss-averse investor’s preference for a lower-risk CA strategy. They constructed a utility model that considered hypothetical investors with varying levels of risk aversion and loss aversion and determined which strategy—CA or LS—each investor might prefer. They found that investors with significant loss aversion may be better suited for a CA strategy.
But Finlay cautions that even if you’re an investor with high loss aversion, it’s best to minimize opportunity costs by keeping a relatively short CA period, such as three months.
“A CA strategy is superior to remaining entirely in cash and, if implemented properly, may be more suitable for risk-averse investors,” she said. “But given the cost of holding cash for extended periods, most investors—particularly those who don’t have significant aversion to loss—should invest a lump sum immediately.”
All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Investments in bonds are subject to interest rate, credit, and inflation risk.
Josef Zorn, Ph.D., CFP®