Investors with a large sum of money have two options: either invest it all at once, which is also known as lump-sum investing, or invest equal amounts of money on a regular and scheduled basis, which is known as dollar-cost averaging.
What is the difference between dollar-cost averaging and lump-sum investing?
Dollar-cost averaging: involves investing equal amounts of money on a regular basis, regardless of market conditions.
Lump-sum investing: involves investing all the money at once.
The dollar-cost averaging strategy reduces overall market risk by spreading investments over a longer time period. Average share purchase prices may be lower over time. In contrast, lump-sum investing exposes all the money to market risk immediately.
Scheduled investing vs. market timing
The dollar-cost averaging strategy helps eliminate emotions from the investing process by scheduling purchases regularly regardless of market conditions. You might have $25,000 available to invest but are unsure of the best time to buy. So, you decide to schedule 10 buy orders, each valued at $2,500 over the next 10 months, whether the market is rising or falling.
Lump-sum investing means investing all the money at once. Instead of spreading out the buy orders over a time period, you take the full amount and invest it all at the most opportune time.
Risks and rewards
As the saying goes, “high risk, high reward; low risk, low reward.” The dollar-cost averaging strategy is often used to help manage market exposure risk, which typically also leads to more conservative returns compared to the potential returns of lump-sum investing.
By scheduling your investments to be processed over a time period, you limit your losses in the event of an unexpected market downturn. This is possible because you did not invest all your money at once. In fact, you may lower your average purchase price because you have scheduled upcoming investments that will likely be executed at lower prices.
While you may reduce overall risk through dollar-cost averaging, you may miss out on potential overall returns. When you have the opportunity to invest all your money at the market bottom, you are investing in small amounts over time, so only the amount invested at the market bottom will achieve high returns.
Nonetheless, lump-sum investing is considered a more aggressive investment strategy, but it often promises significantly higher returns.
When you invest all your money at once, you get full exposure to market growth (or decline). Suppose you have $25,000 to invest and decide to invest it all in an S&P 500 index fund. Over the next six months, the stock market rises by 10%, meaning your entire portfolio also grows by 10%.
If you invested modest amounts only instead of making a lump-sum investment during this market growth period, you would have a lower expected return because only part of the $25,000 is exposed to the 10% overall growth. However, the opposite is also true. If you invested $25,000 in an S&P 500 index fund, the market might decline by 10% over the next six months, leading to greater losses than that faced by an investor using dollar-cost averaging.
Price per share
When you perform scheduled investments regardless of current economic conditions, you are likely to buy more shares when prices are low and less when prices are high. For example, if you invest $25,000 over 10 months without regard to market conditions, you will purchase at various prices. When averaged out, the price per share may be much lower than if you had tried to pick the optimal price and invested all your money in one go.
Considerations
Specifically
When following a dollar-cost averaging strategy, you don’t avoid market losses and might miss out on potential gains in exchange for reducing risk. When investing a large sum, you do not guarantee higher returns and expose yourself to greater market risks.
Depending on the type of investment, you should keep in mind that you may pay higher brokerage fees overall when using a dollar-cost averaging strategy because you are making multiple purchases instead of a single large purchase.
Example of Dollar-Cost Averaging vs. Lump Sum Investment
Let’s assume that investor Mark has $12,000 available to invest. Mark decided to invest this amount in an S&P 500 index exchange-traded fund (ETF). Mark has two options: either invest the full amount all at once and buy $12,000 worth of ETF shares today, or invest $2,000 monthly for six months. Here’s a hypothetical example for each scenario.
If Mark invests the full $12,000 upfront, the purchase price per share would be $100 for a total of 120 shares. This is an example of a lump sum investment.
On the other hand, if Mark invests $2,000 monthly for six months, he may be able to lower the purchase price per share. This is an example of dollar-cost averaging.
By dollar-cost averaging in this case, Mark was able to reduce the average purchase price per share and acquire 121 shares, instead of 120 shares if he had invested the full amount all at once.
Which One Is Right for You?
Dollar-cost averaging may be the better option for investors who:
- want to remove emotions from the investment process and avoid market timing.
- want to reduce market risks over time.
- want to lower their average purchase price per share.
- have little experience in investing.
Lump sum investing may be the better option for investors who:
- do not let emotions dictate their investment decisions.
- have a higher risk tolerance.
- are seeking the highest potential returns.
- have experience researching investments and determining the optimal buying price.
Conclusion
Dollar-cost averaging is an investment strategy that involves investing equal amounts of money at regular intervals, regardless of market conditions. It is a widely used investment strategy to remove emotions from investing, reduce the average purchase price per share, and limit market risks by spreading them over time. Lump sum investing occurs when investors put all their money into purchasing shares at once. They often try to time the market and buy at the best price for maximum potential profit. Lump sum investing comes with higher risks but often promises higher potential returns.
The goal of investing is “buying low and selling high.” Deciding when is the best time to buy is a challenging task. Choosing the right option for you will depend on your risk tolerance, your investment goals, and your overall investment experience.
Source: https://www.thebalancemoney.com/dollar-cost-averaging-vs-lump-sum-investing-which-is-better-5194406
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