Dollar Cost Averaging – Just an average strategy?
Dollar cost averaging is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases, regardless of the price of the security. This helps to reduce the impact of volatility on the overall purchase. The investor purchases more shares when prices are low and fewer shares when prices are high. This strategy can help to average out the cost of the shares over time, potentially reducing the risk of buying at the top of a market cycle, but there are downsides to dollar cost averaging. Lump sum investing is a strategy in which an individual invests a large sum of money all at once, rather than gradually over time. This approach allows an investor to take advantage of market conditions and potentially earn higher returns, but it also carries more risk since the entire investment is exposed to market fluctuations at once.
Pros of Dollar Cost Averaging:
- Averaged cost: Dollar cost averaging can help to average out the cost of shares over time, potentially reducing the risk of buying at the top of a market cycle.
- Forced discipline: Dollar cost averaging can help investors to adhere to a regular investment schedule, which can be beneficial for those who may struggle to consistently set aside funds for investment.
- Less emotional decision making: Dollar cost averaging reduces the need to time the market, which can help investors to avoid making impulsive, emotionally-driven investment decisions.
Cons of Dollar Cost Averaging:
- Reduced returns: If the market is in an overall upward trend, an investor using dollar cost averaging may miss out on the potential for higher returns by buying more shares when prices are higher.
- Higher costs: An investor using dollar cost averaging may pay more in transaction costs, such as brokerage fees, than an investor making a single lump-sum investment.
- May not be suitable for short-term: It may not be suitable for investors who are looking for short-term gains, as it tends to be for long-term strategies.
Pros of Lump Sum:
- Accelerated Compounding: When a large sum of money is invested all at once, it starts earning interest immediately, which can lead to higher returns over time.
- Putting Money to Work: Lump sum investing allows investors to put their money to work right away, meaning they don’t miss out on any potential gains in the market.
- Removes Market Timing: Investing a lump sum all at once eliminates the need for an investor to time the market, which can be difficult and uncertain. This applies to dollar cost averaging in most cases as well.
Cons of Lump Sum:
- Magnified Market Risk: When an investor invests a large sum of money all at once, the entire investment is exposed to market fluctuations at once. This means that if the market goes down, the value of the investment will decrease significantly. This can be especially risky if the investor is close to retirement or has other near-term financial goals
- Cash Requirements: Lump sum investing is that it requires a large amount of money upfront. Some investors may not have a large sum of money available to invest all at once.
What is better: Dollar Cost Averaging or Lump Sum?
I have heard arguments for and against dollar cost averaging. An article from CNBC quoted a study that concluded a lump sum strategy will outperform a dollar cost averaging strategy 75% of the time for an all stock portfolio and 90% of the time for an all bond portfolio. That is quite compelling evidence against dollar cost averaging. However, there is a pretty important variable that needs to be considered and that is the homo sapien. Yes, human behavior and emotion warrants a place in the dollar cost averaging vs. lump sum investing debate. Having all of your investable cash tied up in the market might deliver the best long term returns, but imagine the brand new investor who decided to do that in January 2022 and saw 20% of their wealth disappear, and although the portfolio should recover if the investor just stays the course – there is a difference between staying the course as a seasoned investor and as a rookie experiencing their first bear market. Despite respectable evidence that lump sum is the way to go, I am a proud dollar cost averaging investor, and here is why……
It helps me sleep better at night!!! I feel confident that using dollar cost averaging will not adversely impact my financial plan, and you know what – I sleep better at night knowing that t I am always buying – when the market is up? I buy. When the market is down? I buy. When the market drops 20%? I buy. When the market shoots up 20%? I buy. You get the point….a boring investment strategy is a good investment strategy.
Its part emergency fund, part new opportunity fund, and part anxiety medicine – so I’ll just keep buying. As long as you are within the guardrails of a solid plan you should be fine. Find your place at the rationality party, but make sure you find a comfortable seat in the reasonableness section.
What I love the most about personal finance is that it’s personal! What is your investment strategy? Do you lump sum or dollar cost average investment contributions? I would love to hear your thoughts. Please send them to commoncents@Northbrookfinancial.com.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
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