Good news – you have an extra $60,000, and you’ve decided to invest it in the stock market. It’s always nice to have investable cash on hand. But you may feel that the pressure is on. Nobody enjoys seeing the market take a dive shortly after they jump in. Unfortunately, we never know when it might do exactly that. What’s an investor to do? Should you invest the entire amount right away, or should you invest gradually?
This is the choice between lump-sum investing (all at once) and dollar-cost averaging (over time).
How Do Dollar-Cost Averaging and Lump-Sum Investing Work?
Let's look at an example: Keisha invests $60,000 as a lump sum in a low-cost, total market index fund on January 1. Kevin uses dollar-cost averaging to invest $5,000 per month for one year in the same fund, beginning on the same date. They both let the results ride from January 1 through the next 15 years.
Which Strategy Generates Higher Returns?
Everyone from academics to financial practitioners, to the financial press have weighed in on the matter, and have reached a consistent conclusion: Lump-sum investing generally improves odds for earning higher returns as compared to dollar-cost averaging.
When markets rise, lump-sum investing bests dollar-cost averaging: If you invest everything up front, more of your money has more time to compound in a rising market than if you drip it in slowly. Of course, the reverse is also true. If markets go down, your bigger, earlier stake takes a bigger hit. But …
Overall and over time, markets go up more often than they go down: For example, in this short, but powerful video, Dimensional Fund Advisors shows us that U.S. stock market highs and lows have varied widely in any given year. But despite setbacks along the way, the market has prevailed, delivering a healthy 10% per year, on average, from 1926–2019.
Therefore, it stands to reason: If lump-sum investing outperforms dollar-cost averaging in up markets, and markets go up more often than they go down, then the choice should be clear: a purely rational investor should generally choose lump-sum investing over dollar-cost averaging. But general rules may not always apply to you.
When might dollar-cost averaging be preferred?
Imagine you received $60,000 to invest in early March 2020, just as the COVID-19 pandemic took off, and markets were beginning to falter. If you had decided to invest your lump sum right away, you would have seen it plummet. As it happens, you would have come out fine had you stuck with it through the next two quarters. But nobody knew that at the time; things could have gotten worse.
Would you have been able to stay the course with a March 1 lump-sum decision if markets had taken a turn for the worse? Or would you have leapt back out – or never jumped in to begin with? If you had decided to wait until the market seemed more stable, you’d probably still be waiting.
If investing a lump-sum in early March would have been too daunting, dollar-cost averaging would have been better than waiting for an “all clear” signal that has yet to arrive. By setting up a schedule for dripping your $60,000 into the market over time, you could have benefitted from some of the market recovery, while shielding some of your wealth from further decline.
Let’s look at the big picture
No matter which strategy you choose (lump-sum or dollar-cost averaging), it’s unlikely to matter nearly so much as whether you invest efficiently to begin with.
By this, we mean:
Planning: Start with an investment plan that reflects your personal goals and risk tolerances.
Investing: Invest according to your plan in a balanced mix of low-cost, globally diversified index or index-like funds.
Staying the course: Sticking to your investments over time and through various conditions.
If you follow your strategic plan, exactly how and when you add new money is less significant. The best approach for you is the one that helps you adhere to sensible investment practices.
This content is developed from sources believed to be providing accurate information as of the date of publication, and is intended for informational purposes only. Please consult your financial professionals for specific information regarding your individual situation. Past performance does not guarantee future results. All investing involves risk, including risk of loss.