Is it best to invest your money all at once, putting a lump sum into something you believe will do well? Or should you invest smaller amounts regularly over time to try to reduce the risk that you might invest at precisely the wrong moment?
Periodic investing and lump-sum investing both have their advocates. Understanding the merits and drawbacks of each can help you make a more informed decision.
What is dollar-cost averaging?
Periodic investing is the process of making regular investments on an ongoing basis (for example, buying 100 shares of stock each month for a year). Dollar-cost averaging is one of the most common forms of periodic investing. It involves continuous investment of the same dollar amount into a security at predetermined intervals — usually monthly, quarterly, or annually — regardless of the investment's fluctuating price levels.
Because you're investing the same amount of money each time when you dollar-cost average, you're automatically buying more shares of a security when its share price is low, and fewer shares when its price is high. Over time, this strategy can provide an average cost per share that's lower than the average market price (though it can't guarantee a profit or protect against a loss in a declining market).
The merits of dollar-cost averaging
In addition to potentially lowering the average cost per share, investing a predetermined amount regularly automates your decision making and can help take emotion out of your investment decisions.
If your goal is to buy low and sell high, as it should be, dollar-cost averaging brings some discipline to that process. Though it can't help you know when to sell, this strategy can help you pursue the "buy low" portion of the equation.
Also, many people don't have a lump sum to invest all at once; any investments come out of their income stream — for example, as contributions to their workplace retirement savings account. In such cases, dollar-cost averaging not only may be an easy strategy, but may be the most realistic option.
The case for investing a lump sum
Maybe you just received a pension payout. Perhaps you've inherited a large amount of money, or the mail-order sweepstakes' prize patrol has finally shown up at your door. You might be thinking about the best way to shift your asset allocation or how to invest the proceeds of a certificate of deposit. Or maybe you've been parking some money in cash alternatives and now want to invest it.
In cases like these, you may want to at least investigate the merits of lump-sum investing. Because markets have risen over the long term in the past, investing in the market now tends to be better than waiting until later, since you have a longer opportunity to benefit from any increase in prices over time.
Past performance is no guarantee of future results.
Considerations about dollar-cost averaging
- Think about whether you'll be able to continue your investing program during a down market. If you stop when prices are low, you'll lose much of the benefit of dollar-cost averaging. Consider both your financial and emotional ability to continue making purchases through periods of low and high price levels. Plan ahead for how you'll manage the temptation to stop investing when the chips are down, and remember that shares may be worth more or less than their original cost when you sell them.
- The cost benefits of dollar-cost averaging tend to diminish a bit over very long periods of time, because time alone also can help average out the market's ups and downs.
- Don't forget to consider the cost of transaction fees, which can mount up over time with periodic investing.
Considerations about investing a lump sum
- If you don't have a large lump sum to invest now, you may be able to save smaller amounts and invest the total in a lump sum later. However, many people simply aren't disciplined enough to keep their hands off that money. Unless the money is invested automatically, you may be more tempted to spend your savings rather than investing them, or skip a month — or two or three.
- Seasoned investors have difficulty timing the market, so ignoring fluctuations and continuing to invest regularly may still be an improvement over postponing a decision indefinitely while you wait for the "right time" to invest.
- Diversification alone can't guarantee a profit or prevent the possibility of loss, a lump sum invested in a single security generally involves more risk than a lump sum put into a diversified portfolio, regardless of your time frame.
Deciding between lump-sum investing and dollar-cost averaging illustrates the classic risk-reward tradeoff that all investments entail. Even if you're convinced a lump-sum investment might produce a higher net return over time, are you comfortable with the uncertainty and level of risk involved? Or are you increasing the odds that you won't be able to handle short-term losses — especially if they occur shortly after you invest your lump sum — and sell at the wrong time?
It's important to know yourself and your limitations as an investor. Understanding the pros and cons of each approach can help you make the decision that best suits your personality and circumstances.
This content has been reviewed by FINRA.