To determine which strategy is correct long-term we need to breakdown which is more successful historically, dollar-cost averaging or lump sum investing. While saving long-term to buy when the market is low is not timing the market in the conventional "day-trading" sense, we need to differentiate buying the dip from systematically investing each month regardless of price.
To create context, I would like to highlight 4 variables in the investing formula:
Most people think that the amount of money that you invest (capital) or the investments that you choose (assets) have the largest impact on your total return. This is actually incorrect, time and compound interest have the largest impact on your returns long-term.
However, in order to be effective you need to have them both.
$100 compounded over 50 years will not change your life, and neither will a million dollar portfolio compounded for 1 year.
Individually they cannot achieve their full potential without the other, but together they are the most powerful force in investing.
So which strategy allows us to most efficiently leverage time and compound interest? The answer would most certainly be dollar-cost averaging.
Over the last 15 years, 85% of active equity funds underperformed their index fund benchmarks. If professional fund managers perform below average 85% of the time, then it is safe to say that timing the market is not as easy as it sounds. Couple that with the fact that historically over a 10-year cycle, the stock market is profitable 80% of the time.
The beauty of this question is that we have the historical data to go back and test which strategy would have resulted in a greater return for the investor. Let's run this scenario to analyze which strategy was more profitable over the last 40 years.
According to the United States Social Security Administration, the average income in 1980 was $12,513. We will use this income for both investors, and a savings rate of 25%, $260.70 / month. Both investors will invest in the Vanguard 500 Index Fund with dividends reinvested and earn a return on cash of 2% annually.
Investor A will represent the full potential of investing lump sums of money when the market is down. They will save their money in cash and to technically be the best investor ever, invest in the S&P 500 at exactly the right time, the absolute bottom.
Investor B will represent dollar-cost averaging, investing in the S&P 500 every month, no matter what.
Over the 40 year period, both investors saved 25% of their income, for a total savings of $129,308. Here are the portfolio values after 40 years of investing $129,308 into the S&P 500.
Both Investors invested the same amount of money, in the same investment, over the same period of time, yet one had over $300,000 more than the other at the end of the period, why?
This leads us to the conclusion that over time, asset accumulation is more valuable than purchasing the asset at a good value. Why?
Let's refer back to the investment formula, which investor had their capital deployed in the market for a longer period of time? Investor B, this is significant because it allowed that capital to compound at a greater rate, because it was compounding for a longer period of time.
People spend a lot of time, energy, and effort focusing on things that they cannot control. At some point you have to surrender the emotional and mental horsepower on things that you cannot control and only focus on the things that you can control. You can't control the stock market, but you can control how you invest in it and what you do during downturns.
We cannot control what happens to us, but we can control how we receive what happens to us. Being afraid and allowing that fear to make the decision making process for us is what is what gets us into trouble. The financial markets are a great example of this, the only things that we should spend our time, energy, and effort on are the things that are directly inside our circles of influence and control. Do we have control over what happens in the stock market or the economy? No. What do we have control over at all times? Ourselves, the way we behave, the things that we say, whether or not we allow our emotions to override our decision making process.
If we focus on spending our time, energy, and effort on the things that we can control, we will overcome stressful situations because we have more mental capacity available to us by eliminating focus that was on things outside of our control.
For additional reading, I will refer you to the below Forbes article on the topic.
Should I Invest When The Market Is High? Dispelling The Buy Low, Sell High Myth (forbes.com)
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