Around this time of year is when may employed professionals receive their long-awaited annual bonus. We (ie husband) just got ours, a nice chunk of cash dropped into our bank account. Now the question of what to do with this cash. We know we want to invest it, but how should we invest it?
Investing for the first time can feel like going on a road trip without GPS. Among the many twists and turns and ups and downs, which road or stock to pick, two common strategies stand out as options for putting your money to work in the market. Lump sum investing and dollar cost averaging (DCA) represent two different philosophies of wealth building, each with its own set of benefits and drawbacks. For any investor, understanding the nuances of these strategies is vital to setting a strong course for financial growth.
While both approaches aim to build wealth, they take different paths to reach the same destination. But in a constantly changing market, how does a novice investor choose between these two approaches? Here’s a look at both the merits and risks of both strategies.
Lump sum investing involves putting a sizable amount of money into the market all at once, as opposed to staggering investments over time. This strategy can be particularly tempting when an investor has a large sum of money from, said bonus, an inheritance or the sale of a business or home.
Proponents of lump sum investing argue that by delaying the full investment, you miss out on would-be returns from investing all that capital. This approach is particularly appealing to investors who are bullish on the market's long-term prospects. But if you believe that the long-term market generally goes up, you would invest all your money now.
With lump sum investments, you can start putting your money to work immediately, allowing more time for your investment to grow through compounding interest.
Vanguard research tells us that 68% of the time, lump sum investing outperforms dollar cost averaging. This is based on a one-year investment horizon with a lump-sum strategy versus a three-month cost averaging split (splitting a lump sum into three equal parts and investing each one a month apart).
A common rationale is the belief that the market is temporarily low or will trend upwards soon. When markets are on an upswing, putting your money to work allows you to maximize your returns while riding this wave.
A significant drawback is the exposure to potential market downturns, which can lead to short-term losses.
In 2007-2009, the financial crisis driven by the subprime fallout led to major market turmoil and losses. The S&P 500 declined by over 50% during that time.
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If you had invested a large sum right before the crisis, it would have taken you 5 years to recoup your losses from that investment, had you not pulled out of the market.
For new or risk-averse investors, the psychological impact of a significant loss can be enough to deter them from further investing. Lump sum investing can be a source of heightened anxiety. Loss aversion, or the feeling of experiencing more pain from loss than pleasure from gain, could result in dumping your investments before they have a chance to revert back to their mean growth. Even the natural day-to-day volatility can put folks on edge, which may not be worth the gains later when compared with dollar cost averaging.
Conversely, DCA involves investing a fixed amount of money at regular intervals, regardless of the market conditions. Instead of investing $100,000 at once immediately, you break that lump sum into 12 equal amounts of $8,333 spread out over the initial year. The goal is to smooth out the effects of market volatility by buying more shares when prices are low and fewer when prices are high.
DCA can be less risky, as a steady investment flow can help to avoid the adverse effects of poor market timing with a single, larger investment.
For beginner investors and those with a low risk tolerance, DCA provides a structured approach, which can alleviate some of the fears and anxieties associated with market volatility. Many platforms, like Etrade, allow you to automate scheduled investments on a cadence that works for you, so that it doesn’t become a hindrance to remember to invest each week, month, quarter.
Investors can still participate in the market rather than waiting to capture long-term potential upside
In the worst market scenario, the losses are less compared to a single, larger investment made immediately before a market slump such has the financial crisis we mentioned earlier. In this case, the average cost per share of the securities you purchase over time would be lower than the price per share you would have paid in the lump sum approach.
In a consistently rising market, the early returns from a lump sum investment can surpass the returns from DCA. With compounding interest over a long time horizon, these effects can be significant.
If you have money waiting to be invested, it may not be generating much of a return if it’s sitting in a low-interest savings account. Then your opportunity cost becomes higher — what you could potential make in an alternative investment relative to what you’re making now.
History tells us that markets are cyclical. We know there are bull markets followed by bear markets. But knowing precisely where we are in the cycle is an educated guess at best even for market analysts.
Let’s walk through some examples to play out different scenarios depending on market timing.
It’s September 2007, and we decide to invest $100,000 not knowing that we’re about to enter one of the worst performing market eras ever.
One approach is invest the full amount at once. Another approach is split the sum into 12 smaller but equal amounts, which we’ll invest every month in the first year.
This is what our investment looks like in one year, five years, ten years and 15 years:
In this example, DCA wins out at any point in the future, though the percent difference becomes smaller over time.
Now suppose we begin investing when the S&P is at its lowest in February 2009.
Comparing the same two approaches of lump sum and DCA with 12 payments over the first year, this is what our investment looks like in future snapshots:
In this case, Lump Sum wins out, because we were able to reap the benefits of compounding interest immediately.
What if the market is relatively flat? That’s what 12 months beginning February 2005 looked like for the S&P 500. Comparing lump sum and DCA would show long-term results that are pretty close.
Lump sum and dollar cost averaging can yield varying results depending on the initial market conditions of your investment. Since timing the market is hard, the best strategy is the one that aligns with your unique financial circumstances, risk profile and long-term goals.
But more importantly, the more notable difference is between doing something and doing nothing when you have a long-term outlook. As the saying goes:
It’s not timing the market, but time in the market.
Choose the approach that gets you comfortable with investing, or you will eventually lose out on market gains in the long run.
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