Suppose you have an extra $120,000 and you have decided to invest it in the stock market. It is always nice to have investable cash on hand, but you also might feel as if the pressure is on. Nobody enjoys seeing the market take a dive shortly after they jump in. Unfortunately, we never know when it might do exactly that.
What should an investor do? Should you go ahead and invest the entire amount right away, or should you invest gradually, such as in 12 monthly installments? In financial jargon, this is known as lump-sum investing (all at once) vs. dollar-cost averaging (over time). In more approachable terms, it is often described as “jumping” vs. “wading” into the deep end of the market.
Which one should you use? In terms of raw expected returns, lump-sum investing is preferred. But sometimes there are equally valid, if less tangible, reasons to favor dollar-cost averaging.
Raw Returns
In a match-up of lump-sum investing vs. dollar-cost averaging, which is the better bet? Everyone from academics to financial professionals to the financial press has weighed in on the matter, and they have reached a consistent conclusion: Lump-sum investing generally improves your odds for earning higher returns compared to dollar-cost averaging.
For example, suppose Bob invests $120,000 as a lump sum in a globally diversified portfolio on March 1, and Babette uses dollar-cost averaging to invest $10,000 per month for one year in the same portfolio, beginning on the same date. If they both let the results ride for the next 15 years, who is more likely (although not guaranteed) to come out ahead? The data clearly show that Bob’s lump sum has a better chance of generating more wealth than Babette’s dollar-cost averaging.
“The best approach for you is the one that helps you best adhere to these sensible investment practices.”
This general expectation is well-established in academia, but even without academic analysis, this makes sense because if you invest everything up front, more of your money has more time to compound in a rising market than if you have dripped it in more slowly (of course, if markets initially go down, your bigger, earlier stake takes a bigger hit). Historical data shows that markets go up over a one-year period about 75% of the time, so if lump-sum investing outperforms dollar-cost averaging in up markets, and markets go up more often than they go down, when the choice is available, a purely rational investor should generally prefer lump-sum investing to dollar-cost averaging.
That said, individuals love to wonder whether generalities apply to them. What if you are not yet convinced a lump-sum investment makes sense for you, your personal circumstances, and the latest market conditions? There are some situations in which dollar-cost averaging may be preferred after all.
Considering the Big Picture
First, it is important to emphasize that no matter which way you go (lump sum vs. dollar-cost averaging), it is unlikely to matter nearly as much as whether you invest efficiently to begin with. This means creating an investment plan that reflects your personal goals and risk tolerances, investing according to your plan in a globally diversified portfolio, and having the discipline to stick with your plan over time and through various market conditions. If you can do all that, exactly how and when you add new money is less significant. The best approach for you is the one that helps you best adhere to these sensible investment practices.
Considering your Best Interests
You should consider not only the theoretical performance advantages of lump-sum investing, but also the potential emotional advantages of dollar-cost averaging. For example, imagine you received $120,000 to invest in early March of 2020, just as the COVID-19 pandemic took off, and markets were beginning to falter. If you had decided to invest your lump-sum right away, you would have had to watch it plummet amidst media outcries about “the fastest bear market ever,” “the worst first quarter in history,” and “the most volatile month on record.”
It just so happens, you would have come out okay had you stuck with it through the remainder of the year. But nobody knew that at the time; things could have easily gotten worse instead. Either way, would you really have been able to stay the course with a March 1 lump-sum decision? Or would you have leaped back out, or maybe never jumped in to begin with? If you had decided to wait until the market seemed more stable, you might still be waiting.
If fully investing during the early stages of the COVID crisis would have been too daunting, dollar-cost averaging might have been better than waiting for an “all clear” signal that almost never arrives before the market surges ahead. By setting up an automatic schedule for dripping your $120,000 into the market over time, you could have benefitted from some of the market recovery that has taken place, while shielding some of your wealth had the market instead continued to decline.
Intentions vs. Outcomes
In short, lump-sum investing is generally expected to deliver better long-term returns if you are willing and able to stick with the strategy. But dollar-cost averaging may be the better choice if a more cautious approach helps you better adhere to the larger, more important tenets of efficient investing.
So, how do you decide? This is where a good advisor comes in. Your advisor should help you objectively assess the personal and financial trade-offs involved and help you stick to your well-devised plans over time and through life’s uncertainties. By choosing the investment strategy that makes the most sense for you and your temperament, you stand the best chance of achieving your financial goals, whether you are inclined to wade or jump into the market.