Good news – you have an extra $24,000, and you’ve decided to invest it in the stock market. It’s always nice to have investable cash on hand, but you also might feel as if 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 go ahead and invest the entire amount right away, or should you invest gradually, such as in 12 monthly installments?
In financial jargon, this is known as lump-sum investing (all at once) vs. dollar-cost averaging (over time). In more approachable terms, it’s often described as “plunging” vs. “wading” into the deep end of the market.
Which one should you use? In terms of raw expected returns, lump-sum investing is preferred. But sometimes, there are equally valid, if less tangible reasons to favor dollar-cost averaging. In this two-part series, we’ll explore both possibilities.
Part One: Raw Returns
In a match-up against lump-sum investing vs. dollar-cost averaging, which is the better bet? 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 your odds for earning higher returns compared to dollar-cost averaging.
For example:
- Keisha invests $24,000 as a lump sum in a low-cost, total market index fund on January 1.
- Kevin uses dollar-cost averaging to invest $2,000 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.
Who is more likely (although not guaranteed) to come out ahead? Keisha’s lump sum has a better chance of generating more wealth than Kevin’s dollar-cost averaging.
This general expectation is well-established in academia, at least as far back as a landmark study published by George Constantinides in a 1979 Journal of Financial and Qualitative Analysis article. Others have expanded on the theme ever since, examining nuances such as:
- Do the results still hold using more current data and across various markets?
- Does the advantage disappear after accounting for risk-related returns?
- Might a hybrid strategy (blending both concepts) generate even better results?
So far, the general rule of thumb holds. Even without academic analysis, this makes sense:
1. 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’ve dripped it in more slowly. Of course, the reverse is also true. If markets go down, your bigger, earlier stake takes a bigger hit. However...
2. Overall and over time, markets go up higher and 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, and delivered a healthy 10% per year on average from 1926–2019.
3. Therefore, it stands to reason: If lump-sum investing outperforms dollar-cost averaging in up markets, and markets go up more, and more often than they go down...
When the choice is available, a purely rational investor should generally prefer lump-sum investing to dollar-cost averaging.
That said, we humans love to wonder whether generalities apply to us. What if you are not yet convinced a lump-sum investment makes sense for you, your personal circumstances, and the latest market conditions? This brings us to part two of the match-up between lump-sum investing vs. dollar-cost averaging. The results will be shared soon. The winner has yet to be declared.
In the meantime, feel free to...
This content is developed from sources believed to be providing accurate information. The information in this material is not intended as investment, tax, or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Digital assets and cryptocurrencies are highly volatile and could present an increased risk to an investors portfolio. The future of digital assets and cryptocurrencies is uncertain and highly speculative and should be considered only by investors willing and able to take on the risk and potentially endure substantial loss. Nothing in this content is to be considered advice to purchase or invest in digital assets or cryptocurrencies.
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