Dollar-Cost Averaging vs. Lump Sum Investing Which Might be the Better Option for You

We most often talk about where to invest our money. The funds with the best returns. The lowest costs. The longest track record. However, it is also important to talk about how to invest. Not just where. So in today’s article, we are going to deep dive into two of the most common methods. Dollar-cost averaging and lump sum investing. We’ll deep dive into getting a better understanding of what they are. But more importantly, we’ll discuss how to best apply these methods to our overall investing strategy.

What is dollar cost averaging?

Dollar-Cost Averaging vs. Lump Sum Investing
Pic Credit: Market Sentiments

First, let’s talk about dollar cost averaging. If this is your first time hearing this term, no worries. It’s quite simple and after reading this article, you should be able to easily explain it to your significant other. “Dollar-cost averaging,” also known as DCA, is a phrase that refers to investing regular amounts over time. Such as weekly, monthly, or quarterly. Rather than investing all your money in a fund at once.

Now, why would anyone do this? We primarily do this to mitigate against market timing. Market timing is a strategy in which investors buy and sell stocks based on expected price changes. If investors can predict when the market will go up and down, they can make trades to turn that market move into a profit. However, when you are investing consistently in the market, you don’t have to guess when the market is up or down.

You are constantly buying when the market is up. And when the market is down. Thus in effect reducing the impact of volatility on the overall purchase of assets. Let’s look at an example. Let’s say that you invested $1,000 today and the market dropped by 20% tomorrow. You just technically lost $200. However, if you are investing at a regular interval over time, you hedge against any drop in price because when the fund just dropped, you also get to pick up shares at a discounted price.

So in the long run, your share price averages out. And this is a good strategy to mitigate against human tendencies to market time. Because, Market timing, regardless of what the financial media might tell us, is almost impossible to do. The Motley Fool’s defined market timing as “a strategy based on predicting short-term price changes in securities, which is virtually impossible to do.” And they are not the only ones that feel this way.

In 2002, Warren Buffett stated in his annual letter to shareholders that: “Forecasts tend to produce fantasy.” – Warren Buffet And Morgan Housel, the author of “The Psychology of Money” has said “The odds that you will achieve long-term success by actively trading or timing the market round to zero.”- Morgan Housel All said, dollar cost averaging is an excellent strategy to get around our knee jerk reaction to try to market time.

And most of us are already dollar cost averaging. We just never looked at it that way. If you have set up a 401(k) contribution at your day job, and money is automatically taken out of your paychecks and invested, you are applying the dollar-cost averaging method. Your paycheck comes out at a set time every month and your 401(k) contribution is made outside of your timing.

While the 401(k) contribution is the most common method of automatic dollar-cost averaging, some opt to do this manually even when they have a lump sum of cash available. For example, if you had $20,000 in savings, you could spread that out over the course of 12 months (evenly) instead of investing it all at once. Now is this a good strategy if you have some control over how you can invest? Let’s find out.

What is lump sum investing

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But first, let’s talk about Lump Sum investing. Lump-sum investing is when you take all of your available dollars to invest and put it right into the stock market. If you have the money available, you don’t spread it. You get it to work for you right away. It’s the opposite of dollar cost averaging. However, there is a nuanced line between dollar cost averaging and lump sum investing.

If you are intentionally holding cash to invest it later, that would be considered dollar cost averaging. But you can still make periodic investments and consider it a lump sum investment. For example, let’s say you receive a periodic bonus from your day job for a job well done. This could be quarterly, semi-annual or annual. And every time you get this bonus, you decide to invest it right away.

Even though you are making periodic investments based on when you receive the bonus, this is still a lump sum because you aren’t holding onto that money in order to invest at a later time. However if you had held onto that bonus and spread it out over the coming months, then now you are dollar cost averaging. It feels a bit nuanced, but it’s important to understand the difference.

What does the research say is better?

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So the big question is. What is better? What produces better results? Dollar-cost averaging or lump sum investing? Interestingly, Vanguard 2012 research found that lump-sum investing actually beats dollar-cost averaging. They looked at the difference between dollar-cost averaging and lump sum investing by assessing different stock to bond allocations in three different countries: the United States, United Kingdom, and Australia. It looked at rolling 10-year periods from 1926 to 2011.

They found that at the end of the 10-year period, the lump-sum investment led to greater portfolio values approximately two-thirds of the time. Even when results were adjusted for the higher volatility of a stock to bond allocation versus cash investments. And this result was consistent across all three markets. The United States, United Kingdom, and Australia.

The study’s recommendation was this: invest the lump sum immediately to gain exposure to the market as soon as possible. And other studies have supported these findings as well. A similar study done by Northwestern Mutual, primarily in the US market found similar results. They concluded that Lump-sum investing outperforms dollar cost averaging almost 75% of the time regardless of asset allocation.

In simple layman’s terms, the bottom line is this. Because the market normally goes up, investing early produces higher returns in most situations. However, I do want to highlight another interesting finding from the Vanguard study. The study showed that during a market downturn, dollar cost averaging resulted in less frequent losses than lump sum investing.

When comparing the number of times an investment declined in value, lump sum investing declined in value 22.4% of the time whereas Dollar cost averaging was down only 17.6% of the time. Of course, this is the number of times a portfolio was down. Not the amount it was down. But the takeaway from this is that dollar cost averaging favors investors who are focused on avoiding losses.

If you are a type of investor concerned with minimizing downside risk and potential feelings of regret, resulting from lump-sum investing immediately before a market downturn, then dollar cost averaging may be of use. Of course, any emotionally based concerns should be weighed carefully against the lower expected long-run rate of return. And the fact that delaying investment is itself a form of market-timing, something very few investors succeed at.

Practical advice

Alright, So how do we apply these findings to our investment strategy? Let me share with you a few practical recommendations and what I personally do. And let me just come out and say that, despite what the research says, I do still love dollar cost averaging. And this is primarily due to the psychology behind investing. Most often, more than technical knowledge or special insight, psychology plays a bigger role in our returns than what or how we invest.

Benjamin Graham said it most wonderfully: “In the end, how your investments behave is much less important than how you behave.” – Benjamin Graham We aren’t rational beings and at the end of the day, I still like dollar cost averaging because it helps us to keep us from trying to time the market. So when it comes to our 401(k). Where we take a part of our monthly paycheck and invest, continue to dollar cost average.

Ignore the ups and downs of the market and just set it and forget it. Your contribution is buying when it is low and buying when it is high. And if you have a traditional 401(k) plan, most likely you won’t have a choice in the matter anyway. When it comes to our IRA where we have more of a choice. If you have the cash, I would recommend a lump sum investment at the beginning of the year. And max it out if you can.

For both the Traditional and Roth IRA, the 2022 contribution limit is $6,000 per person. Max out your contribution as well as your spouse if you can afford it. I’m reminded of a common saying in the investment world. “It’s not timing the market, but time in the market that matters.” Put your money to work for you as soon as possible, so it is working for you as long as possible.

But let’s say that you don’t have a lump sum amount to max out your IRA. No problem. Then I would recommend dollar cost averaging to align with when you receive your paycheck. The lump sum would have been nice, but what’s more important is the fact that you are contributing, not when. What I like to do is to set up automatic monthly contributions so money is being invested at the same time each month.

This not only saves you time but takes you completely out of the market timing temptation. And this strategy would apply to any other investment accounts that you have. Brokerage investment account, 529 college savings plan, Donor Advised Fund, etc. Any account where you are investing. Lump sum if you can. If not, not a big deal. Dollar-cost average as you can afford it.

And when you do receive a lump sum of money, invest it right away. Don’t worry about dollar cost averaging and definitely don’t try to time the market. I get into this dilemma constantly when I have some extra cash. I can’t help myself from looking at how the market is currently doing and am hesitant to put money in the market when it seems high. However, I have to constantly remind myself that I have no idea if the market is at its peak or at the bottom.

Take a look at this chart. This chart shows the market historical returns for the past 100 years. There are literally hundreds of points where people must have thought the market was too high or too low. The bottom line is none of us knows. So invest early and often. And implement the dollar cost average method whenever lump sum is not possible.

DISCLAIMER: I am not a financial consultant. These articles are solely for educational and entertaining reasons. I’m only expressing my personal viewpoint. Please seek professional assistance if necessary.

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