Dollar Cost Averaging Vs Lump Sum investing
Introduction
What Is Dollar-Cost Averaging, Pros And Cons
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Pros
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Cons
What is Lump Sum investing?
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Pros
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Cons
Which One Is Better To Start Investing?
Summary
Introduction
In this article we will compare what dollar cost averaging and Lump Sum Investing have to offer. Both strategies have proven successful in the recent years, but we know how difficult it can be to predict the results in the market. Let’s see the important details of these two investment strategies.
What Is Dollar-Cost Averaging, Pros And Cons
Let’s start with dollar-cost averaging, it is an investing strategy that consists of accumulating long-term assets in an installment plan where, instead of using all the money available for a purchase at once, those funds are distributed in installments and at fixed times to always buy the same dollar amount of an asset on a specific monthly purchase date.
For example, if you want to invest $12,000 to buy an asset in a DCA model, you could buy $1,000 dollars of the asset on the 15th of each month for a year.
If the price of the asset is the following
January – $100
February – $95
March – $85
April – $95
May – $80
June – $70
July – $85
August – $90
September – $95
October – $105
November – $120
December – $125
Your average cost using Dollar Cost Averaging will be $95
If you buy $1,000 worth of the asset each month you will have $16,095 at the end of the year versus buying the asset with a lump sum of $12,000. If you bought $12,000 worth of the asset in January, you will have $15,000 at the end of the year.
Pros
Dollar Cost Averaging aims at minimizing the potential impact of investing in the market when the time is not right, thereby reducing the effects of asset volatility, so it is more beneficial for inexperienced traders, who do not have the necessary knowledge to know what is the best time to buy or sell in the market, for this reason, any time is good to start carrying out this strategy, which generates long-term profit.
Cons
If you want to invest with DCA, Dollar Cost Averaging does not protect us 100% against the risk of investing during a bad market, as there are other factors to consider. However, applying a DCA strategy minimizes the consequences of a bad investment. Also remember that your purchases will be small market entries, which will give you the feeling that your earnings are small, but remember that it is a long term strategy. Also, investing in small increments like this will incur fees and higher commission costs, as compared to single investments, but as this is a long-term strategy, the profits earned should cover the commissions that will later become insignificant amounts.
Another disadvantage is that Dollar Cost Averaging does not perform better in a bull market, since in such markets it is more feasible to invest all the capital at once.
If you think we are headed for a bull market then there is a very different strategy to that of Dollar Cost Averaging, where the timing in the market is calculated or “predicted”…
What is Lump Sum investing?
Lump Sum Investing is an active strategy that focuses on current market conditions and requires close attention and monitoring of the market. By investing all at once, you enter the market earlier and benefit for a longer period of time from the trend and compound interest.
The decision to invest a lump sum in the markets is easily accompanied by a common fear: “What if the market crashes tomorrow?” Or next week? Or in the next 5 months? The truth is that we do not know…
Lump-sum investing means that you take all or a large portion of your investable cash and invest it all at once. Some investors choose this approach because, if they get the timing right, they can generate above-average returns, as such, with lump sum buying, you should look to buy the dip. however, perfectly predicting the markets on a continuous basis is nearly impossible.
A lump sum could be $1,000, $20,000, $100,000 or any amount that is large given your situation. But by using a large sum of money, you will be able to hopefully buy a large sum of and asset at a low price.
Let’s look at another example.
If you want to invest $12,000 to buy an asset using the Lump Sum Investing model, you could research an asset and notice that the 52 week high is $150 and the 52 week low is $70. You wait for it to reach $70 and then buy $12,000 dollars of the asset in May. The following price fluctuations occur:
January – $150
February – $100
March – $80
April – $100
May – $70
June – $80
July – $85
August – $100
September – $150
October – $125
November – $140
December – $160
If you bought the asset in May for $12,000 using the Lump Sum model, you will have $27,427 at the end of the year versus using the DCA model where you would only have $18,520.
As you can see the two investment strategies work better in different environments.
Pros
If you are clear about the advantages of investing all at once i.e., more profitability and simplicity, and you can mentally assume the supposed additional risk you will come out ahead with Lump sum investing. For a long-term investor, it pays to put your money to work as soon as possible. Lump sum investing means you don’t have to try to figure out the best time to make regular investments on a monthly basis. You can set up your portfolio and let it grow. You also do not pay fees for each monthly purchase of shares of the asset. Lump Sum Buying works best in a bull market and when you can accurately identify a good market price and time to buy an asset, you will reap big rewards.
Cons
On the other hand, to make a lump sum investment you need to have a lump sum to invest. If you do not have the money, you will have to raise the money by selling existing assets or borrowing money which could add to your overall risk.
Another disadvantage of Lump Sum Buying is that you need to be able to know when dips are occurring in the market or know when the market is bottoming. These are often skills that are more related to trading. With such a strategy, one must be careful not to overleverage. The price you pay for the investment can be high or low. If you invest when prices are high, you run the risk of incurring huge losses if you need to sell when the market drops.
But now, let’s analyze the advantages of both strategies… Each works best in a different market environment. So both strategies will have disadvantages that you should be aware of before choosing one.
Which One Is Better To Start Investing?
Warren Buffet had this to say on the best investing approach:
“If you like spending six to eight hours per week working on investments, do it. If you don’t, then dollar-cost average into index funds.”
Lump Sum Investing and Dollar Cost Averaging have different objectives. Each method is useful depending on what one wants and we can even combine them.
Lump-sum investing carries greater risk, accompanied by the potential for higher returns, while dollar cost averaging limits overall risk and can provide more conservative returns. The best choice for you will depend on your investment objective.
Dollar cost averaging may be more suitable for investors who:
● Want to avoid market timing
● Want to limit market risk over time
● Have little investment experience
Lump-Sum investing may best suit investors who:
● Have a higher risk tolerance
● Seek to achieve the highest potential returns
● Have experience researching investments and determining the optimal buying price.
A good approach to combining these strategies would be to dollar cost average into an S&P 500 Index Fund and when you have large sums of money come in, put a portion of it into the fund as well. That way you are taking advantage of the benefits of both approaches. The S&P 500 Index Fund is a fund that tracks the overall stock market and has historically risen over the years. There are years where it has taken a significant downturn but it always climbs higher after several months. The problem is you do not know which year may be the downturn, so be sure to consult with a financial advisor and do not take this as financial advice.
Summary
Lump-sum investing and dollar cost averaging are not mutually exclusive. It may seem that putting an entire investment into the market at once is riskier than doing it gradually or consistently. But there is not more risk in one and less in the other. They are simply different risks and different benefits.
Whatever option you choose, the most important thing is that you start investing to achieve your long-term goals and protect your money from inflation.