Should you invest a large amount of money at once or should you gradually enter the market? It is one of the most debated about questions among investors. A data analysis shows that those who speculate on the so-called cost-average effect and invest in slices usually perform worse than an all-in strategy. So now it happened. You just received a lot of money. Perhaps a relative died and left you a fortune. Maybe you sold your business. Maybe you won the lottery. Regardless of how you got the money you’re sitting on, now you’re going to ask yourself:
Should I invest this capital immediately or should I invest gradually?
Investors often ask this question. I understand the fear they are about to invest their money. Much is at stake. Hundreds of thousands, maybe millions of dollars. What if the market crashes right after investing? Wouldn’t it be better to invest gradually in order to benefit from the so-called cost average effect, also known as dollar cost averaging or average cost effect, and to avoid an unfortunate entry point? Statistically, the answer is no. In a study from 2012 shows that, 66 percent of the time it was better to invest the money immediately than to spread the sum over 12 months and gradually buy into the capital market. No advantageous cost-average effect in rising markets. Because of this positive long-term trend, the cost average investor typically buys at higher average prices than the instant investor. In addition, it is difficult to stick to this strategy in the rare cases in which the cost-average effect is beneficial. Because it is only superior to a one-off investment in falling markets. In times when it is most agonizing for investors to stick to their investment plan.
Cost-average effect versus one-off investment
In order to compare an immediate one-time investment with the cost-average effect, I examine the returns that a one-time investment and a cost-average strategy achieve in the same “purchase period”. By the purchase period I mean the period in which you invest the same amount every month until your capital is fully invested. For example, you can spread your investments over six months, twelve months or longer periods. At the end of the purchase period, the strategy that achieved a higher return has won.
Why? Once the cost average strategy is fully invested, all subsequent returns of the two strategies will be identical. So if the salami tactic has achieved 10 percent more returns over twelve months than the one-off investment, this lead will remain in the future.
Time in the market beats timing the market
Think about how groundbreaking this is. In the last 60 years, the chance was only 50:50 that you would do better with a cost-average strategy over 24 months in a portfolio of 100 percent stocks than with an immediate one-off investment in a portfolio that only consists of safe government bonds. Of course the example is pretty absurd. No investor who ultimately wants a pure equity portfolio would start with an investment in 100 percent government bonds. But the example shows that even if you had done something so illogical, you would have been similar to a pure equity strategy that relies on the cost-average effect.