Which is the best sum? Dollar-Cost Averaging Vs. Lump-Sum Investing
You need to decide whether you want to stretch it out or put it all into an investment now if you have money to spend and want to earn the best sum. Read here my average dollar-cost vs lump-sum investment breakdown.
Do you think about spending it if you join or have a lump sum of cash? If you don’t, you have to. But with a large amount of capital, there are various techniques you can employ. You may spread it over time or quickly throw it into the stock market.
But what is the best method?
In this post, I will discuss the difference between Dollar Cost Average (DCA) and Lump Sum Investment so that you can figure out which is better for you.
What is the difference between dollar-cost averaging and lump sum investing and which is the best sum?
The biggest difference between the average cost of the dollar and the lump sum investment is when you invest in the stock market. With the dollar-cost average, in some intervals you spend small amounts of your money. On the other hand, the lump-sum investment is where you take all the money that you have to spend at that time and put it all in one spot.
In a little more depth, I’ll discuss these below.
An overview of the average dollar-cost
Investment of your money periodically – including weekly, monthly, or quarterly – in stocks and ETFs is called an average cost of dollars (often referred to as DCA). A 401(k) account has been set up by most of us at our employers, and money is automatically taken out of our paychecks and invested in a number of funds. If you did so, you would have used the dollar-cost average.
While that is the most popular dollar-cost averaging process, with dollar-cost averaging, you can take another path. For example, if you have a lump sum of cash in a savings account, you might opt to spread the money out over a certain period of time and gradually spend it. If you had $20,000 in savings, for instance, you could spread it out (evenly) over the course of 12 months instead of spending it all at once.
The biggest draw to this approach is that you don’t put every dollar you have on the stock market at once and take the risk that the market will drop unexpectedly, and so will the value of your portfolio. Since past performance is nothing more than a piece of knowledge and no one can predict future returns, averaging dollar costs allows you to invest your money emotionally in riskier assets (such as stocks) without feeling the risk as much.
An overview of investing in a lump sum
In the other hand, lump-sum investment is when you spend all of the available dollars and place them right on the stock market. It’s the opposite of the average dollar cost, because you’re not waiting to invest, it all goes into your chosen investments immediately. Now, between DCA and lump-sum investing, there is something of a fine line. Only let me clarify.
I can chalk it up as a dollar-cost average if you’re actively holding on to cash to spend it later. But you can also invest annually and consider it to be a lump sum investment. For instance, claim that you’re getting a $10,000 quarterly bonus. You plan to spend it each time you get the bonus. While you are making periodic investments, this is still lump-sum investing. The explanation is that for a later time, you’re not deliberately hanging onto the capital.
If you were to take the $10,000 quarterly bonus instead and spread it over the next year, in three equal monthly instalments, THAT would be the average dollar cost. It may seem like semantics, but the difference can really mean more or less money in your portfolio when you look at the details (more on this below).
Who is averaging the dollar-cost for and not for and is it the best sum?
For anxious investors with lower risk exposure and who have greater amounts of money sitting around in something like a high-yield savings account, dollar-cost averaging works very well. By spreading your investment into smaller chunks, you can mitigate your risk, while still holding cash in a safer investment, such as a CD.
If you can spread your investment out for a longer period of time, you can also benefit from dollar-cost averaging. If you invest your money too fast (for example, within three to six months), after a major upswing or downswing, you can not give the market enough time to correct itself.
Coronavirus is a perfect example, as things have been unpredictable, and if you spend it too quickly, you won’t get the most benefit from your DCA approach. If you’re taking this approach, I suggest spreading it out over 12 to 36 months. I also suggest setting it up as an automatic investment plan so that by doing it manually, you do not bail out on your contributions.
DCA is not for those who want to spend faster on the flip side, are all right with the ups and downs of the economy, and do not want to keep extra cash in lower-yield instruments such as CDs or bonds.
Who is lump-sum investing for and not for?
Lump-sum investment is a technique requiring a high degree of tolerance for risk. It’s a risk to take. A lump sum investing plan will advise you to pour all of the money into your savings at once if you have $20,000 to invest. Through doing so, you run the risk that the stock market will inevitably tank (just like what happened in March due to the coronavirus pandemic). Instead, it can go up and you win out, which is why it’s a gamble.
So if you have money to spend, and you’re all right with the fact that you could lose that money, and you’re willing to take that chance, then saving a lump sum is a great choice for you. Although there is an inherent danger, the prospect of major gains still exists. Imagine that you had spent $20,000 this past March, right after the stock market tanked. Until now, you must have enjoyed the ride of a significant market turnaround.
Similarly, whether you’re concerned with the risk of losing your savings, or if you want to have some spare cash set aside instead of being invested for emergencies, lump-sum investing is definitely not for you. Even if you can make the investment by yourself, individuals who are internally uncomfortable with it will encounter discomfort and make emotionally-based trading decisions, which are never healthy.
Does it matter which one you are selecting?
Hey, yes and no. No, it doesn’t matter from a personal and psychological point of view, but from a data and statistical viewpoint, it does matter. What I mean here is:
I like to compare this claim with the argument put forward by Dave Ramsey: the Debt Snowball. The Debt Snowball makes no sense mathematically. First, Ramsey recommends paying off the smallest balance, then the largest one next, and so on. This technique ignores interest rates, because the most rational path isn’t actually taken, but it works on a psychological level.
That, to me, is where the average dollar cost wins over lump-sum investing. It doesn’t actually make sense mathematically (I’ll tell you why in a moment), but it gives your investment plan a degree of psychological protection by allowing you to have cash on hand in case of an emergency AND spend some money along the way.
What the studies reveal
Much like any investment strategy that seeks to minimize risk (such as investing in stocks, for example), there are downsides to dollar-cost averaging. Simply put, an ordinary dollar-cost investor would miss out on major price fluctuations while they are holding their capital aside for the next cadenced investment deposit. The market may have already reversed itself by the time the capital is ready to be spent, and you have missed out on the benefit.
One research, conducted in the early 1990s by two finance professors, looked at historical stock market data spanning about 70 years. Their results found that someone who invests a lump sum received better returns in their first year about 67 percent of the time than someone who followed the average dollar cost and dripped their investment over the course of the year.
A more recent study by Vanguard looked at the disparity between dollar-cost and average and lump sum investments by investing in a portfolio of 60/40 (stock/bond) in three different countries. They noticed that a lump-sum investment in each sector contributed to higher portfolio values about two-thirds of the time. They did variants of this test and also saw very comparable outcomes.
Finally, a study published in the Journal of Financial Planning by Robert Atra and Thomas Mann in 2001 states that “the findings (of different studies) suggest that DCA is neither as efficient as the claims of personal finance literature, nor as suboptimal as the claims of academic literature.”
What they’re saying is that, from a statistical viewpoint, dollar-cost averaging isn’t what it’s cracked up to be. It offers some degree of protection, but at the expense of increased returns.
Pick a successful broker irrespective of the tool you choose
It is up to you whether you want to use dollar-cost averaging or lump sum investing. But you need to make sure you have a strong online broker you’re working with, regardless of the tool you use. Here are a few of my favourites at the moment:
You Invest by J.P. Morgan
You Invest gives you an opportunity to invest with You Invest Trade or You Invest Portfolios on your own, which will give you a controlled portfolio of 0.35 percent per year for a low fee. Both account forms come with clear account management, best from J.P. in class expertise. Morgan Chase, and a number of Chase features for incorporation.
You may use any account form when it comes to dollar-cost averaging. Without paying fees, You Invest Trade helps you to pick your own stocks and invest over time. You Invest Portfolios, on the other hand, will allow you to create a managed portfolio into which you can periodically drip capital. You Invest Trade is excellent for lump-sum investment, because you won’t have to pay fees on your larger trade.
E*TRADE is far and away one of the best investment sites that you can be on, if not the best. With the amount of instruments and services they have, the specialized investment maps you can utilize, and their exclusive account characteristics, they blow most other online brokers away. They aren’t the cheapest, but give E*TRADE a look if you’re a serious long-term investor.
What’s unique about E*TRADE is the fact that they have E*TRADE Savings Bank for dollar-cost averaging, where you can get a checking or savings account. Not only can you space out your deposits, but as you wait to invest, you can hold the cash in a high-yield savings account, all with one broker. And things like the Technical Pattern Recognition Method and Spectral Analysis will help you make the right investment for the first time for lump-sum investments.
So while the evidence shows that lump-sum investment is a better long-term option, it doesn’t actually mean that it’s going to be the right strategy for you. Investing is emotional and you should be fine as long as you hold those feelings in check and stop making rash decisions.
But part of that feeling is feeling confident about what you’re investing in, which is when you would find DCA useful. Either way, make sure you understand the nuances and find a broker who is going to work with what you need.
Their results show that approximately 67 per cent of the time, a man who invests a lump sum received more earnings in his first year than someone who averaged dollar-cost and dripped his investment over the year.
The average dollar cost decreases investment risk and capital is retained in order to prevent a market collapse. There was a mistake. A deteriorating economy is also seen as a purchasing opportunity; thus DCA will dramatically increase the potential for long-term portfolio returns as the market continues to grow.