How much money you're able to sock away is likely to be a key determinant of success in achieving your longer-term financial goals. Besides maximizing savings, however, you're also going to face another important wealth-building issue:

Should I use a dollar cost averaging (DCA) approach to deploy my investment capital, or simply make a lump sum contribution to my IFA Index Portfolio?

Let's say, for instance, you've received a large bonus or inheritance. Then again, perhaps you're looking to put to work proceeds from the liquidation of a business. Or, maybe you've sold several actively managed funds. Either way, in a dollar cost averaging scenario, you could choose to contribute a set amount each month and contribute to your portfolio in equal amounts over several months. By contrast, you could simply contribute that entire lump sum into your portfolio right away.

Although how much is contributed and how long this process plays out can vary greatly, one fact of a free-market structure remains etched in stone: Securities are priced to produce a positive expected return over time. As a result, we would expect a "wading in" type of DCA strategy to underperform a lump sum investment more often than not.

A Hypothetical Comparison

To dig deeper into this question, we've compared monthly returns for the all-stock and globally diversified IFA Index 100 Portfolio. In this hypothetical study, the period (Jan. 1, 2003-Dec. 31, 2022) was broken into several different shorter timeframes. The basic parameters used were:

• For lump sum, we assumed the entire sum ($180,000) was immediately invested into IFA Index Portfolio 100. This represented a completely arbitrary amount chosen as a random placeholder — i.e., we could substitute almost any initial number into this hypothetical study and find similar patterns of returns through such an extended period.
• For the DCA side, the same sum was transferred in equal increments of $10,000 into the IFA 100 portfolio over an 18-month period. (We used one-month U.S. Treasury Bill returns as a proxy for the risk-free rate of holding an investment like cash.) 

As you can see from the chart below, a lump sum investment of $180,000 at the beginning of 2003 would've wound up with an ending balance of more than $1 million. By contrast, a dollar cost averaging strategy during this 20-year period produced nearly $854,000 — representing $209,182 less. 

In some cases, an investor might feel hesitant to lump sum, especially with a fairly large amount. But it's important to remember that a DCA approach stashes a meaningful amount of investment capital in cash. For those with a goal of accumulating wealth, this represents a real opportunity cost.

The urge to time such an investment decision based on short-term market conditions might still be tempting to a lot of people. Instead of viewing it as contributing to a longer-term and holistic portfolio strategy, our wealth advisors too often find investors react out of fear. A common concern is: What if I make a lump sum investment today and prices drop tomorrow?

After all, if funds increase in value each month during this period, the DCA investor will pay a higher price on average than if investing all upfront. On the other hand, if the market decreases steadily over many months, the opposite could be true.

Taking Another Look

As a result, we've expanded our lump sum versus DCA study to look at return patterns over shorter investment horizons. (See chart below.) As in the previous scenario, the lump-sum results were calculated assuming the entire amount was invested into an IFA Index Portfolio 100 at the outset.

To figure returns for a DCA strategy, the same sum was transferred in equal increments into the IFA 100 portfolio over a period of six, 12, 18, 24, 30 and 36 months. This encompassed: 235 rolling six-month periods; 229 rolling 12-month periods; 223 rolling 18-month periods; 217 rolling 24-months periods and 211 rolling 30-months periods. Then, we compared the performance of each of these rolling periods between the lump sum and dollar cost averaging studies to see which performed better in the majority of circumstances.

As indicated by such a review, the lump sum strategy overwhelmingly outperformed in every case, whether it was over a shorter or longer timeframe. Notice, too, how a more patient approach increased the odds of lump sum investing producing even greater odds of portfolio success. Still, it's probably worth noting that such a winning pace didn't always follow a straight line. Indeed, some 21% of the time such a DCA methodology came out ahead over 36 months. (Again, though, let's not forget that by comparison a lump sum investment prevailed 79% of the time.)

Given that markets are naturally volatile and market-timing can be such a frustrating (to say the least) endeavor, we've tried to remove much of the guesswork out of the lump sum versus DCA equation. This hypothetical exercise should help to put into clearer perspective the potential ill effects of letting your investment dollars linger in a cash-like vehicle or account. It's an issue we've written about in the past. (See: "The Nasty Aftereffects of Holding Too Much Cash.")

As those examples of holding varying amounts of cash over longer timeframes indicate, exposing your IFA Index Portfolio to standalone instances of "cash drag" using a dollar cost averaging strategy can be quite detrimental. While the future is uncertain, lessons learned from the past should comfort those who remain disciplined and focused on following a holistic financial plan — one which can be developed and tracked on a complimentary basis for each IFA client.

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This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful.  Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. Take the IFA Risk Capacity Survey (www.ifa.com/survey) to determine which portfolio captures the right mix of stock and bond funds best suited to you.  For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com.