Over the last couple of weeks, we have been asked about the merits of investing a large lump
sum amount into an investment portfolio or dollar cost averaging into your portfolio. This is a
great question and plays into the psyche of investing as well as the long-term financial
implications of investing. Many investors worry about buying stocks when they are on the rise
and may instead put off purchasing them until you see a "dip", however, this can be a difficult
thing to do as stocks on average rise over time and you do not know when a dip will occur. This
means that waiting for the dip is a form of market timing which is very difficult to do. Dollar
cost averaging can be a way to assist with the psyche of buying the dip.
BENEFITS OF LUMP SUM INVESTING
When we talk about lump sum investing, we mean putting a large chunk of money to work in
your portfolio right away. This needs to be consistent with your individual asset allocation
strategy, this may be all stock or a combination of stocks and bonds. The largest benefit of this
is that markets - both stocks and bonds are positive on average over time. It is the simple
notion that time in the market is one of the largest contributors to portfolio returns. This is
shown with a great study by Vanguard in 2012 that showed from 1926 to 2011, Lump sum
investing outperformed dollar cost averaging roughly two thirds of the time.
BENEFITS OF DOLLAR COST AVERAGING
Dollar cost averaging is the act of systematically investing the same dollar amount at set
intervals. For example, if you said I am going to put aside $1000/month to buy a certain stock or
bond, in a month when that stock went down you would be able to buy more shares and if it
went up you would buy less shares. This approach can help the emotional aspect of investing
by reducing the fear of the market going down right after you invest a lump sum. Typically, this
may be used for more conservative investors. In addition to that it is a great way and a common
way to invest in your 401k.
WHAT STRATEGY IS BETTER FOR ME?
This is a great question and one that takes many different factors into account. Here are a
couple of factors to think about in making a decision. To start, always remember to analyze
what your time horizon is for investing, do you need the money next month or in 20 years? The
longer your time horizon means that generally you can have a higher degree of risk. Secondly,
understand your emotions and the investment impact. If there is a large sense of fear and
anxiety around lump sum investing then it may be worth analyzing Dollar Cost averaging. Also,
if you have an asset allocation including stocks and bonds or other assets in your investment
portfolio, remember when stocks go down you may be able to rebalance your portfolio to
purchase more stocks on the dip by selling other assets.