If you have recently begun to invest in the stock market, or have a sum of money at your disposal that you would like to invest, you are likely uncertain which course of action to pursue - Dollar-Cost Averaging or Lump Sum Investing?
To make the best decision, it is important to weigh the pros and cons of each technique to decide which is most suitable for you.
Dollar-Cost Averaging (DCA) is an investment strategy, in which the investor allocates a fixed dollar amount to a certain investment or security at fixed and regular intervals. For instance, an investor might allocate $200 to a stock on the same day of each month. The aim is to reduce the risk exposure of any one investment and diversify the investor's assets.
Some of the risks that DCA can reduce include the risk of buying stocks at overly inflated prices and the risk of market volatility (sudden and rapid price movements). By investing a fixed amount at regular intervals, the investor can purchase more shares when the price is low and less when the price is high, effectively reducing the average cost of ownership.
Lump sum investing is the opposite of dollar-cost averaging. Through lump sum investing, an investor allocates a large sum of money at once to a certain security or asset, rather than investing a fixed amount at regular intervals.
This method attempts to take advantage of positive changes in the stock market. When stock prices are low, the investor can acquire a large number of shares in a company for less money invested. If prices continue to rise, they can benefit more from the stock's appreciation.
Due to its aggressive nature, this method also carries increased risk. The investor puts all of their eggs in one basket, and is impacted more severely in the event of large market downturns, where stock prices decline significantly.
- Lower risk if stock prices move against the investor, the average purchase price will be lower than if they had chosen to buy all their shares at once. The investor can diversify risk across all the purchase dates they use. They don't have to worry about market timing, or deciding when to invest their capital to maximise returns. This can be very helpful for those without a large amount of investing experience.
- The regular payment option may be more suitable for investors on a budget or those who are investing on behalf of someone else.
- The investor has the potential to receive higher returns due to the effect of compounding. If stock prices go up - the investor will benefit more from their larger upfront investment amount.* The investor can diversify their risk across multiple industries, countries, or currencies by investing the lump sum in several different assets.* The investor benefits from the economies of scale - which is the lower cost of operations due to buying in bulk.
- The investor accumulates less returns over time, as they will purchase more shares when prices are high.
- Due to inflation, the regular payments should increase in accordance, to take inflation into account. If the investor does not adjust their payments to keep up with inflation, they could be worse off regardless of market movements.
- The investor may suffer from frustration, due to missing potential gains in the market.
- If stock prices fall before the investor is able to invest, they may lose out on buying cheaper shares.
- If the investor invests in one market but it’s a bad decision, then they will experience sudden losses. If the same investor had spread the investment out over several markets or assets, the negative impact would be reduced.
A 1993 study "Lump sum beats dollar-cost averaging" in the Journal of Financial Planning found that lump-sum investing performed better, over a period of 35 years, when compared with a dollar-cost averaging strategy. The difference between the two strategies was smaller when the timeframe was shorter, for example 5 - 10 years.
Another more recent research paper "A simulation model for deciding between lump-sum and dollar-cost averaging" studied the impact of a lump-sum versus DCA strategy over a 19-year period. The study found that the worst time to invest was in the second and third years from the investment date. The results suggested that lump-sum investing was better in the majority of cases.
However, even though lump-sum investing performed better in many scenarios, it is important to keep in mind that it carries a greater risk of higher volatility compared to DCA. Ultimately, it is the investor's risk appetite and goals that will determine which strategy works best for them. You need enter the market when it’s bearish to get the face value of the stock.
Therefore, if you are a conservative investor willing to stay away from large losses and volatility, a dollar-cost averaging strategy may be the most suitable option. If you are comfortable taking some risk for potentially increased returns, a lump sum investment may be more suitable.
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