In the process of deciding when to invest your dollars, you can choose to spread them out over time, or dump it all into the stock market right away. This is the question of Dollar cost averaging vs Lump sum investing. But which method is best?
In this article, I’ll go over the difference between dollar cost averaging (DCA) and lump sum investing so you can determine which is best for you.
The difference between dollar cost averaging and lump sum investing is when you invest in the stock market. With dollar-cost averaging, you invest small amounts of your money at certain intervals over the course of time. This is diametrically opposed to lump sum investing, which is when you take all of the money you have available to invest at that period of time, and invest it all at once.
I’ll discuss this in a little more detail below.
A brief description of dollar cost averaging
Investing your money at regular intervals – on a weekly, monthly, or quarterly basis – in things like stocks and ETFs is considered dollar cost averaging (DCA). Many of us have set up a 401(k) contribution at our jobs, and funds are automatically taken out of our paychecks and invested in a variety of funds. If you’ve done that, you’ve used dollar-cost averaging.
While that is the most common method of dollar-cost averaging, you can take another route with dollar-cost averaging. For example, if you have a chunk of cash in your bank account you can elect to spread that money out over a certain period of time and invest it gradually. For example, if you had $12,000 in savings, you could spread that out over the course of 12 months (evenly) instead of investing it all at once. This method is primarily used to reduce downside risk.
The major benefit to this strategy is that you aren’t putting every dollar you have into the stock market at once and taking the risk that the market will suddenly drop, and so will your portfolio’s value. Since past performance is nothing more than a piece of data and no one can predict future returns, dollar-cost averaging is a huge help mentally. Being able to buy more shares at a lower price when you’ve lost money is beneficial to investor psychology, and will help you to not sell at the bottom but instead continue buying.
A brief description of lump-sum investing
Lump-sum investing, on the other hand, is when you take all of your available dollars to invest and put it into the stock market all at once. It’s the opposite of dollar-cost averaging, so you don’t wait to invest – it all goes into your chosen investments right away. Now, there is somewhat of a fine line between DCA and lump-sum investing. Let me explain.
If you’re intentionally holding on to cash to invest it later, I chalk it up as dollar-cost averaging. But you can still make periodic investments and consider it a lump sum investment. For example, say you get a yearly bonus of $15,000. Every time you get that bonus, you decide to invest it. This is still lump-sum investing, even though you’re making periodic investments. The reason is that you’re not intentionally spreading that investment out over time.
If you were to instead take the $10,000 quarterly bonus and invest it over the coming quarter, in equal weekly installments THAT would be dollar-cost averaging. It might seem like semantics, but when you look at the data, the difference can actually mean more or less money in your accounts.
Who is dollar-cost averaging for and not for?
Dollar-cost averaging works really well for nervous investors with lower risk tolerance and who have larger sums of money sitting around in something like a high-yield savings account. You can minimize your risk by spreading out your investment into smaller chunks, while still keeping cash in a safer investment, such as a CD.
You’ll also benefit from dollar-cost averaging if you can spread your investment out for a longer period of time. If you invest your money too quickly (for example, over three to six months), you may not give the market enough time to correct itself after a big upswing or downswing.
During a bear market is when you’ll get the most value out of a DCA approach. Studies show spacing out an investment over 12 months in a bear market is almost always better than lump sum investing. Also, I recommend setting it up as an automated investment plan so you don’t bail out on your contributions by doing it manually.
On the flipside, DCA isn’t for those who want to invest faster, are okay with the ups and downs of the market, and don’t like keeping extra cash in lower-yield vehicles like CDs or bonds.
Who is lump-sum investing for and not for?
Lump-sum investing is a strategy that requires a high level of risk tolerance. It’s taking a gamble. If you have $20,000 to invest, a lump sum investing strategy would tell you to dump all of that money into your investments at once. By doing that, you run the risk that the stock market can tank immediately (just like what happened in March due to the coronavirus pandemic). Alternatively, it can go upward and you win out – hence the reason it’s a gamble.
So if you have money to invest and you’re okay with the idea that you could lose that money, and you’re willing to take that risk, then lump-sum investing is a great option for you. While there is an inherent risk, there’s also the possibility of huge gains. Imagine if you’d invested $20,000 right after the stock market tanked this past March. You’d have enjoyed the ride of a significant market rebound thus far.
Likewise, if you’re uncomfortable with the risk of losing your investment, or if you want to have some extra cash set aside for emergencies instead of it being invested, lump-sum investing probably isn’t for you. Even if you could bring yourself to make the investment, people who are internally uncomfortable with it will experience anxiety and make emotionally-based trading decisions – which is never good.
What the studies show
Just like any investment strategy that aims to reduce risk (like investing in bonds, for example), dollar-cost averaging has downsides. Put simply, a dollar-cost averaging investor will miss out on massive swings in the market because they’re keeping their money aside for the next cadenced deposit toward that investment. By the time the money is ready to be invested, the market may have already corrected itself and you’ve missed out on the gain. This is essentially the idea of opportunity cost and is a real risk to DCA investors.
One study done by two professors of finance in the early 90s, looked at historical stock market data, spanning around 70 years. Their findings showed that around 67% of the time, someone who invests a lump sum gained higher returns in their first year than someone who followed dollar-cost averaging and drip-fed their investment over the course of the year.
Another study that was done more recently by Vanguard, looked at the difference between dollar-cost and averaging and lump sum investing by investing in a 60/40 (stock/bond) portfolio in three different countries. They found that in each market, a lump-sum investment led to greater portfolio values approximately two-thirds of the time. They did variations of this test and saw very similar results, too.
Finally, a study done by Robert Atra and Thomas Mann in 2001 in the Journal of Financial Planning states that “The results (of various studies) suggest that DCA is neither as effective as the personal finance literature claims, nor as suboptimal as the academic literature claims.”
What they’re saying is that dollar-cost averaging, from a statistical perspective, isn’t all it’s cracked up to be. It provides some level of safety, but at the cost of increased returns.
