Key Takeaways
- In contrast with dollar-cost averaging, lump-sum investing is a strategy in which the total investment capital is employed all at once.
- A general rule is that with the lump-sum approach, investors may generate somewhat higher annualized returns than dollar-cost averaging.
- Generally, DCA is used more for volatile investments, mutual funds or stocks, instead of certificates of deposit or bonds.
This article offers a clear comparison between two fundamental investment strategies: dollar-cost averaging and lump-sum investing. Here we will provide investors with practical insights to help them choose the approach that best aligns with their financial goals and risk tolerance.
Understanding Dollar Cost Averaging
With dollar cost averaging, a fixed dollar amount is invested incrementally on a regularly recurring basis, typically monthly.
The underlying idea is that spreading the purchase of publicly traded securities including stocks and exchange-traded funds over a protracted period can allow the investor to skirt share price fluctuations.
A major part of the strategy’s appeal is that it eases the psychological strain that is common when attempting to time what are inherently volatile markets. The approach is particularly suitable for novices with little to no market experience and those with regular income streams for which investments can be made.
Generally, DCA is used more for volatile investments, mutual funds or stocks, instead of for certificates of deposit or bonds.
DCA Pros:
- Mitigates the effects of “investor psychology,” or trying to time the market. Investors can avoid making unproductive or poor decisions based on emotions such as fear or greed.
- The strategy can also work if an investor believes there is a chance the investment opportunity could drop over the short term, but that over the longer term, it will rise.
DCA Cons:
- If the investment price goes up while using dollar-cost, the investor could wind up purchasing fewer shares than they would have at the outset with a lump-sum investment.
- Investors who use the strategy usually have funds held in cash that earn markedly low return rates. This excludes 401(k) and similar holdings since contributions are made to those accounts as funds are earned.
- There will likely be trading fees from making multiple transactions from the trading account.
Understanding Lump-Sum Investing
In contrast with dollar-cost averaging, lump-sum investing is a strategy in which the total investment capital is employed all at once.
There are scenarios in which lump-sum investing might be more suitable, such as when an investor is receiving a windfall. In that case, it is relatively more common for the investor to put a large portion of their inheritance in the stock market. Whether that is the right move depends upon the economy’s health and other factors.
Lump-sum Investing Pros:
- Capital can be deployed immediately, which can be beneficial over longer periods.
- Potentially higher returns, thanks to the power of compound interest. For example, $10,000 invested for 50 years at 10% interest will yield around $1.45 million. Waiting a decade and investing that cash for just 40 years will yield the much smaller amount of $537,000.
- Timing the market is not required because the investor is only investing once.
- Just one brokerage fee. Again, the investor is making a single investment.
- Fewer worries. When going with a lump sum approach, the investor need not worry about market fluctuations.
Lump-sum Investing Cons:
- The movements of short-term markets are unpredictable. Putting all one’s capital into the market at once during a period of volatility could reap significant losses that could take a number of years to recoup.
- It may be difficult coming up with a lump sum. And waiting too long to invest could result in the investor missing time in the market.
- Susceptibility to impulsive picks. Investors may be more apt to impulsively pick stocks.
Comparing Advantages and Disadvantages
A general rule is that with the lump-sum approach, investors may generate somewhat higher annualized returns than dollar-cost averaging, according to a Northwestern Mutual Wealth Management study.
Compared to lump-sum investing, contributing to one’s portfolio via smaller amounts may be a better way to ease into the market, according to FINRA, especially if there is concern about the market’s outlook.
If investors have a relatively low risk intolerance, states WealthyEducation.com, they may become unsettled if they put capital in the market all at once and prices fall.
Real-World Examples
An investor made the initial of a number of investments just prior to a sharp drop in share prices and incurred an unrealized loss solely on the portion invested to date – not the whole amount they intended to invest. That dollar-cost averaging strategy could work even if the initial returns are unfavorable.
If another investor has $24,000, with the lump-sum strategy, all the capital is invested in the first month. With DCA, though, $2,000 is invested in the first month and the remaining $22,000 is held in cash to be invested in payments of $2,000 over the next 11 months.
Insider Tips for Investors
Here are some tips on deciding between DCA and lump sum, factoring in personal financial situations and risk, market conditions, market trends, and investment goals.
- DCA may be a better strategy for investors who have a relatively lower risk tolerance, since they otherwise will be more subject to timing risk.
- When employing a dollar-cost averaging approach, it is important to determine whether the reason underlying a stock price drop has significantly affected the reasoning for the investment. If it has not, the investor may opt for gaining the shares at an even better price.
- Investors disbursing a large sum may wish to spread it over just a year or two, as any longer than that could cause the investor to miss a general market upswing.
- If an investor is worried about investing their lump sum, it could be because they are investing in a portfolio that is excessively risky for them.
- In addition, even for investors with high risk aversion, opportunity costs may be minimized by limiting the DCA period to around three months.
Investment Strategies and Diversification
No matter what strategy an investor uses, diversification is key. The practice of spreading one’s investments among varying asset classes, with different risks and anticipated returns, is necessary for long-term investing success.
For example, diversification is a chief reason why investors are increasingly turning to private investments such as art, real estate, and other asset classes offered by the leading platform Yieldstreet to establish a portfolio mix that not only can mitigate overall risk and protect against inflation, but possibly offer improved returns.
