How to make the most of a lump sum investment

If you’ve ever found yourself in receipt of a lump sum of investable cash, you’re not alone.

A 2021 report from the Productivity Commission found that between 2002 and 2018, the total value of wealth transfers in Australia was approximately $1.5 trillion. With the Baby Boomer generation now aged between 60 and 78 years old, this number is projected to increase fourfold between 2020 and 2050¹.

When faced with this situation, the obvious question that follows is: how best to invest a large chunk of money?

You’ve probably heard of dollar cost averaging (DCA) – spreading the investments out across multiple, equal investments – but is it really the best way to invest a lump sum? Or is it better to put it in the market all at once?

A brief note on regular investment plans

In this article, when we refer to DCA, it’s in the context of an investor who has a lump sum to invest.

This differs from regular contributions, such as those made through superannuation, allocating a portion of your fortnightly salary to a brokerage account, or using the Auto-invest feature on Betashares Direct. The analysis here may not apply to regular investment plans, where a lump sum is not involved.

What does the research tell us?

Interestingly, PWL Capital, a Canadian firm managing $3 billion in assets for over 1,000 families, explored this issue globally, including for Australian investors.

The firm observed that its clients were increasingly encountering windfalls from selling homes, businesses, receiving inheritances, or even winning the lottery. However, the challenge came in deciding how to invest these large sums.

“Whatever its source, shifting from cash into stocks can be a nerve-racking experience,” wrote Ben Felix, the company’s Chief Investment Officer.

In an analysis, Felix compared rolling 10-year returns across a range of developed markets covering at least 50 years of data for each market. He found that lump sum investing (LSI) outperformed DCA nearly two thirds of the time, resulting in an average outperformance of 0.38% p.a. on an equal-weighted basis.

LSI vs DCA for 10-Year Historical Periods

Source: PWL Capital, analysis by Ben Felix. Data sourced from Dimensional Returns Web, CRSP, MSCI, S&P Dow Jones Indices, and PWL Capital. Excluding the US and Canada, the data covers the period from January 1970 to March 2020, with performance measured over 10-year intervals to calculate average outcomes for each approach. For the US and Canada the data starts at January 1926 and February 1956 respectively.

He specifically found that in Australia, the LSI strategy improved performance by 0.32% p.a. over a 10-year period, while in the US, this figure increased to 0.41% p.a. “The basic insight from this result is that, on average, LSI leads to greater ending wealth than DCA,” Felix wrote.

Moreso, the analysis showed that even when stock prices were expensive and during bear markets, LSI still produced higher returns than DCA².

What factors are driving these outcomes?

Simply put, LSI has tended to perform better than DCA because the returns on stocks are positive most of the time. Analysis by First Trust Portfolios based on Bloomberg data shows that between 1936 and 2021, the S&P 500 Index produced positive returns over a month 63% of the time³.

Since DCA involves gradually entering the stock market, leading to reduced exposure until fully invested (resulting in what’s known as “cash drag”), it’s expected that LSI would deliver better returns more often—which is exactly what the data shows.

Psychological benefits and market timing risks

The analysis above considers the mathematical comparison between the two approaches as this is relatively easy to quantify. However, there may be psychological benefits to DCA, which are largely intangible.

Consider this: how would you feel if a $1 million inheritance dropped to $700,000 versus increasing to $1.3 million? Unless you’re very experienced with markets, such a loss would likely be concerning.

This reaction is supported by the groundbreaking 1979 study, Prospect Theory: An Analysis of Decision Under Risk, where Daniel Kahneman and Amos Tversky found that people feel the pain of losses more intensely than the pleasure of equivalent gains⁴.

Mitigating this fear of loss may prevent investors from making a mistake, such as abandoning their investment strategy after a significant loss.

However, as Felix explains in his paper: “If DCA seems like a solution to avoiding pain when investing new money, we think that is a reasonable strategy.”

“However, we also think that if the fear of loss is so great that DCA needs to be employed to make an asset allocation decision palatable, that asset allocation may be too aggressive,” he says.

In other words, if DCA allows you to enter the market at a pace that feels comfortable, even if it statistically underperforms LSI, it’s still beneficial because it aligns with your investing style and ultimately gets you into the market.

However, it’s important to remember that portfolio construction is crucial, as asset allocation ultimately determines approximately 90% of investment returns.

Two ways to implement a strategy

Regardless of whether you choose to DCA or make an LSI, these tools can be used to implement your strategy.

Set and forget

If you prefer a ‘hands-off’ approach, an all-in-one diversified ETF like DHHF Diversified All Growth ETF  offers a simple way to put your strategy into place. It provides exposure to around 8,000 small, medium, and large companies from Australia, developed markets, and developing markets.

DHHF rebalances the portfolio quarterly to ensure allocations stay close to the strategic asset allocation targets. It also offers the lowest management fee among all-in-one diversified ETFs available on the Australian market – just 0.19% p.a.⁵

Schedule recurring orders

With Betashares Direct, you can use Auto-invest to easily schedule recurring investments in up to 5 Betashares ETFs, making it simple to automate a dollar cost averaging (DCA) investing strategy.

Select the ETFs you want to invest in, the amount you want to invest on each order date (minimum of $100 per order), how often you want to invest this amount, and the date you want to start.

There are no fees and no brokerage to schedule recurring orders using Auto-invest.

Refer to the PDS for information on interest retained by Betashares on cash balances. ETF management costs apply.