When it comes to investing your money, there are primarily two strategies you can use: lump sum investing and dollar cost averaging. Both of these come with advantages and disadvantages. In this post, I will walk you through both, showing you why you might choose one over the other and ideally, help you to determine which method makes the most sense for you and your goals.
What Is Lump Sum Investing?
Lump sum investing is fairly straightforward. You have a chunk of money to invest and you invest all of it at once. So, if you have $10,000 you want to invest in the stock market, you do it on a given day.
The advantage of lump sum investing is that you are sure to get into the market. You won’t be tempted to go out and buy things with the money, like a new car or smart phone instead of investing it.
The disadvantage of this method is that you might invest all of your money when the market is at a peak and end up spending some time, possibly years, waiting for the market to recover.
For example, imagine if you had invested the $10,000 right before the markets crashed in 2008. You would have had to wait until 2011 at the earliest just to get back to your starting amount of $10,000. To avoid the chance of this, you can elect to implement dollar cost averaging instead.
What Is Dollar Cost Averaging?
Dollar cost averaging is simply taking your money and investing it over a period of time. Using the example from above, if you had $10,000 to invest, you could use this strategy and invest $1,000 per month for ten months. Or you could invest $500 a month for 20 months.
The amount you invest each month and duration is up to you. The question you might have is how does this strategy work exactly? Here is an example.
Dollar Cost Averaging Example
For this dollar cost averaging example, I am going to use real-life data so I can’t fudge the numbers to make things work one way or the other. I am going to use the Vanguard 500 Index Fund (VFINX) as the investment choice. I am going to invest $1,000 each month for 10 months on the first business day of each month.
I will use January 2, 2015 as my starting date (and invest $1,000 each month through October) and then look at the ending value as of June 17, 2016 which is when I calculated the data for this example.
In the chart below, you will see the ending daily value for VFINX as well as how many shares I was able to buy for $1,000. I rounded the purchases to 4 decimal points as most mutual funds do.
After I make the final investment in October of 2015, I own a total of 53.9244 shares.
Fast forward now to June 17, 2016 and we see that the VFINX closed at 191.94. By taking the number of shares I own and multiplying that by 191.94, my total investment is worth $10,350.25. I ended up gaining $350 by dollar cost averaging.
Dollar Cost Averaging vs Lump Sum Investing
If you are curious, you probably want to know what would have happened if I had just went ahead with lump sum investing instead. Here is what would have happened. I would have invested all $10,000 into the VFINX on the first business day in January 2015 and owned 53.9957 shares as a result.
Fast forward to June 17, 2016 and my investment would be worth $10,363.93. I gained $363 by using the lump sum investing strategy. This strategy ended up earning me an additional $15 compared to dollar cost averaging.
So is dollar cost averaging not worth it? Should you just use lump sum investing all of the time? The answer isn’t so simple.
Does Dollar Cost Averaging Work?
Based on the examples from above, you are probably thinking that using dollar cost averaging does not work and isn’t worth the hassle. After all, you would have made more money by lump sum investing as opposed to dollar cost averaging. But there are some key reasons as to why you should not completely rule out dollar cost averaging as an investment strategy.
Goal of minimizing risk: when you use dollar cost averaging, you minimize risk by investing over a period of time. You have no idea when the market is at a peak, so by systematically investing each month for a period of months, you lessen the risk of investing at the wrong time.
Buying low: another reason to look into dollar cost averaging is to buy low. Any decent investment book you read will tell you to buy low. The problem is that when emotions and money interact, we rarely buy low. We most likely buy high – when everyone is excited and making money hand over fist as seen in the chart below.
You should be investing at the opposite time – when the market is dropping. You will buy more shares and will have a greater return when the market goes back up.
It works: finally, dollar cost averaging works, especially over the long term. When I speak of the long term, I mean over 10 years or greater. Yes, the lump sum strategy I pointed out works better here, but that is only over a period of roughly a year. You need to look long term.
Many of the arguments against dollar cost averaging won’t look this far ahead. They will point out one year or two years later how you would have been better off investing with a lump sum.
So should you use dollar cost averaging all of the time? Unfortunately, the answer is still not so simple.
Disadvantages Of Dollar Cost Averaging
So those are the reasons why you should consider dollar cost averaging but what are some disadvantages of dollar cost averaging? Here are some reasons.
High costs: if you are looking to use a dollar cost average strategy when investing in stocks, the price of the broker commissions hurt you enough that lump sum investing is a better option. The only exception to this is if you invest with a firm like M1 Finance.
In this case, you can buy a basket of stocks for one low fee. But even then, make sure you are investing enough so that the broker fee makes up 1% or less of your total investment.
You’re a worrier: if you are easily spooked when it comes to investing, a lump sum strategy might be better for you. The reason is because you can invest once and be done. With a dollar cost averaging strategy, you might get scared and skip an investment month here and there. Doing this will hurt you tremendously, mainly because the most likely outcome is that you will spend the money instead.
You’re stuck on an investment: another reason to skip dollar cost averaging is if you are in love with a loser. By this I mean a stock that is dropping each month. You might get excited that you are buying low and owning more shares each month, but the truth is you are just throwing money away on a stock that is going nowhere. An example of this would be Enron. You can also read my experience with this when I was investing in Worldcom.
By investing a little amount over time, you guarantee that you will be investing your money and saving for the future. Many mutual fund companies even let you invest as little as $50 or $100 each month. In fact, just about every one of us uses dollar cost averaging when investing in our 401(k) plan.
At the end of the day, dollar cost averaging is a viable option when investing your money. If I wanted to, I could have played with the numbers enough to prove my point without a shadow of a doubt, but that wouldn’t be totally honest.
What you need to do, is to sit down and understand you goals and risk tolerance. Once you complete this step to becoming a stock market millionaire, you can decide which investing strategy, dollar cost averaging or lump sum investing, works best for you and your goals.