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Dollar Cost Averaging vs. Lump Sum Investing

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dollar cost averagingDollar cost averaging is one of those terms that gets tossed around the investing world a lot!

Dollar cost averaging is when you have a chunk of money that is ready to be invested today and you plan for that money to be invested at different time intervals rather than putting all of your money in the market at once (lump Sum investing).

Dollar cost averaging is typically done with a 6 month – 12 month time window and you commit a certain percentage of the funds to be invested at each investment date (typically quarterly or monthly).  This could be 25% four times a year or 10% ten times a year – whatever you decide is best for you.

What Dollar Cost Averaging is Not

Do not confuse this market timing method with continuous automatic investing.  With continuous automatic investing you are investing on a regular basis indefinitely no matter what, think of your 401k as an example.  You do not have a lump sum of money ready to invest, but instead have small amounts every month.

Why specify the difference?  Because most of the articles and research that is presented in the media are merging the two issues together.  Here is how you should differentiate them in your mind.

If you have a large sum of money that needs to get invested, then you may consider dollar cost averaging which is what the remainder of this article is about.

If you are looking to begin investing and you are looking at investing regularly over time for the foreseeable future then you are continuous automatic investing and you do not need to worry about dollar cost averaging or lump sum investing.   If you are continuously investing simply move forward with selecting your investment and setting up a regular contribution amount, do not waste your time confusing the issue since you don’t have the option to invest with one big lump sum.

When to Consider Dollar Cost Averaging

Why would you consider dollar cost averaging?  Most fans of dollar cost averaging claim that it reduces market risk.  Market risk is the risk that the market as a whole will lose value.  They claim that risk is reduced because it allows you to lower your per share cost by investing at different price points therefore you get more shares when the market is lower and fewer shares when the market is higher lowering your overall cost basis,  reducing risk and improving your return.

This is only true if two things are occurring at the same time, the market is going down the entire time you are making these investments and that you are speculating and not investing.

The problem with assuming the market is going down is that over time it goes up and you cannot predict what the market is going to do in the short term.  If you could perfectly forecast what was going to happen in 9 months, you would not worry about dollar cost averaging as you would wait till the day you know the market will be the lowest. (Plus you would not be reading this as your special skill would have made you rich!)

Speculating is trying to make a profit on an asset based on price fluctuations, an example would be a day trader.  Investing is trying to make a profit on an asset based on analysis of the underlying goods that will produce value in the future.

In addition for the purposes of an investor they are not looking to take their money out of the market for at least five years.  Less than five years and the market is too volatile for the money to be there in the first place.

So if the market normally goes up and you cannot predict when it will go down, and you are investing the money and not trying to make a quick buck on the price fluctuation, and you are not planning on selling the investment in the next five years then it is better to get in the market with a lump sum as soon as possible.  Analysis of the data for many years has shown that it is always better to invest lump sum at the beginning of the year.  I have placed an example at the end to show you the hypothetical differences of an investment done through dollar cost averaging and lump sum investing.

Factors to Consider When Dollar Cost Averaging

  • Transactions costs are fees that are charged every time you make a purchase.  These can be commissions with a broker or brokerage companies, load fees and sometimes both.  If you are dollar cost averaging these charges will be higher and can eliminate any benefits of gaining a lower cost per share.  You are able to avoid the transaction costs if you are buying a no-load mutual fund through the company directly.
  • Opportunity cost is the cost of something that you are giving up to do something else.  In dollar cost averaging one of the costs that you are forgoing is the benefits that you might receive from a mutual fund or stock such as dividends, interest and capital gains that occur while your money is not in the market.  As an easy example let’s say that you forgo the opportunity to buy 100 shares of GE Stock in favor of waiting for 3 months.  In that time they declare a dividend that would have been $25 for your 100 shares.  This is a cost of waiting to purchase using dollar cost averaging.
  • Finally the last factor has nothing to do with money; instead it is your emotions.  If you have never invested before or have little experience with investing then dropping a large chunk of money into the market can be a scary thing.  Using a dollar cost average approach could ease you into the world of investing and allows you to continue to learn along the way making the entire process less scary.

So if you have a lump sum, I encourage you to just get the money in the market now, unless emotionally that would cause you to lose sleep.  If that is the case try your best to find options that do not have transaction fees and move forward with an investment plan that works for you.

Example:

In the below example I used a market that went up for half the time and then down have the time.  Other examples I ran are all up and all down markets.  The only time dollar cost averaging works is if it is a down market.

Date Purchased Amount Invested Price Per Share Shares Purchased Lump Sum Once Shares
January $10 $2.50 4 $240 96
February $10 $2.60 3.85
March $10 $2.70 3.7
April $10 $2.75 3.64
May $10 $2.80 3.57
June $10 $2.85 3.51
July $10 $2.87 3.48
August $10 $2.90 3.45
September $10 $2.92 3.42
October $10 $2.95 3.39
November $10 $3.00 3.33
December $10 $3.04 3.29
January $10 $3.00 3.33
February $10 $2.90 3.45
March $10 $2.88 3.47
April $10 $2.80 3.57
May $10 $2.79 3.58
June $10 $2.75 3.64
July $10 $2.69 3.72
August $10 $2.60 3.85
September $10 $2.58 3.88
October $10 $2.50 4.00
November $10 $2.40 4.17
December $10 $2.30 4.35
Total $240 87.64 $240 96.00
Average $2.75
January values Value Gain
Dollar Cost Avg $2.25 $197.18 $-42.82
Dollar Cost Avg $3.50 $306.73 $66.73
Lump Sum $2.25 $216.00 $-24.00
Lump Sum $3.50 $336.00 $96.00