This is a question that plagues new investors everywhere: is it better to invest the cash you have all at once or spread it out over a few weeks or months?
Many people come into a lump sum to invest through a variety of ways: income tax refund, work bonus, inheritance. Your lump sum may be as little as $1,000 or as large as $500,000. Chances are, the larger it is, the more worried you are about what to do with it!
But the lump sum vs dollar cost averaging conundrum is the product of emotional investing, not rational investing. The math has been done many times, and lump sum investing does better than dollar cost averaging. However, feelings of fear of loss make many people more comfortable with a dollar cost averaging approach.
Here’s how to find out what is best for you.
What is dollar cost averaging?
Dollar cost averaging is the practice of investing a fixed amount of money, or buying a fixed number of securities at regular intervals. You can do this on weekly, monthly, or even quarterly basis.
Dollar cost averaging is a great way to invest, because it keeps you investing no matter what the market is doing. Inevitably, you’ll sometimes buy when the stock market is up and at other times you’ll buy when the stock market is down. However, over time you’ll get a great average prices on the securities you add to your portfolio.
The main attraction of dollar cost averaging is it can reduce your anxiety of investing all at once only to see the stock market crash the next day. With dollar cost averaging, you only have a little bit of cash at stake at a time, so mentally and emotionally you perceive the risk of investing to be much lower.
We tend to think of investing every payday or once a month when we transfer money to our investment accounts as dollar cost averaging, but this is actually rapid lump sum investing. Dollar cost averaging would involve holding back most of your money and waiting to invest later.
What is lump sum investing?
Lump sum investing is the practice of investing all available cash in the stock market as soon as you have it. If you receive a $20,000 bonus from work or an inheritance, you invest that $20,000 as soon as it hits your account, as opposed to investing a few hundred or thousand dollars at a time over the course of weeks or months.
Research shows that lump sum investing will outperform dollar cost averaging at least 75% of the time, regardless of portfolio allocation. For a fixed-income portfolio, lump sum investing will outperform dollar cost averaging 90% of the time!
This means that if you have a properly balanced investment portfolio of stocks and bonds, there’s about an 80% chance that lump sum investing will give you a higher ROI than dollar cost averaging.
While lump sum investing tends to outperform dollar cost averaging, investors perceive their risk to be higher. It feels more psychologically painful to dump a large sum into the stock market all at once, even though is what is most likely to earn you the highest return!
It’s possible the stock market will crash the day after you invest a lump sum of cash in index funds, but it’s even more likely it will continue to go up.
Is lump sum or dollar cost averaging better?
Based purely on financial returns, lump sum investing is better than dollar cost averaging. If you have a chunk of change to invest, you’re better off getting it into the market as soon as you can instead of trying to spread it out over a longer time frame.
But we are not robots that make decisions purely based on mathematics. There is an emotional ROI to our decisions! You have to make the decision that will give you the greatest financial return while giving you the least amount of anxiety. For many people, lump sum investing just feels too uncomfortable and they can’t help breaking down their cash windfall into smaller chunks to invest.
How to choose between lump sum and dollar cost averaging
- If you don’t already have one, open an investment account with a roboadvisor or a self-directed account with a brokerage. It should take you an hour or two to complete the account set up, and then 3-4 days to transfer your money into the account.
- Acknowledge that lump sum investing tends to outperform dollar cost averaging. Understand that while it might feel more comfortable to wait, it’s likely not to be the right choice. Your goal is to get your money into the stock market the fastest. If you’re not willing to do it all at once, it’s time for the next best thing.
- Determine the maximum amount you’re willing to invest right now. You might not feel comfortable dumping your entire lump sum into the market today, but certainly there is a large amount you can tolerate. Maybe it’s 25%. Maybe it’s 50%. Whatever it is, invest the most you can emotionally tolerate right away!
- Come back in a week and part with the maximum you’re willing to invest again. A week from now, open your brokerage account again and see how you feel. Chances are, investing your first amount and not having the world end has probably given you some confidence to invest more. Now is your chance to invest the rest of your balance, or again, invest the maximum amount you can emotionally tolerate.
- Repeat step 3 as many times as necessary.
The “reason” that I believe this is so is that it is generally understood that investments tend to rise over time. Psychology, business, and inflation tend to result in bigger numbers as time goes on.
Therefore, earlier money will tend to win out over later money. And, btw, dollar cost averaging does not really tend to happen over years, but rather weeks and months, so even if you picked the 2008 Great Recession or even the 1930’s Great Depression, all that dollar cost averaging would do is be the same as a lump sum.
So to me, it is not a great mystery why lump sum is better. It just “tends” to go up from wherever you added the money. The goal is to invest when things are low, whether during a recession/depression or at a peak – because it will turn out to be a low anyway, looking back on things from the future…
Human nature, and all.