Most of the time, index fund investors will invest at regular intervals, such as weekly or monthly. Occasionally though, we may be lucky enough to come across some extra money. This may be from the sale of a house, an inheritance, a bonus payment, or maybe you are thinking about starting to invest.
Naturally, this leads to one of the most common investing questions. Should I invest it all at once (lump sum), or spread the contributions out over a longer period of time (dollar cost average)?
In part five of the investing series, I briefly touched on Dollar cost averaging, but we will expand on that here.
Dollar cost average or lump sum?
Most common advice is to invest it all at once. People can get very parochial over their opinions on this matter, but it is not always the best option. Just like most personal finance decisions, it is not that black and white.
The reason lump sum investing is so heavily favoured is because stock markets tend to trend upwards two thirds of the time. This essentially means that if you invest now, you have a 67% chance that the markets will trend upwards after you invest your lump sum. Hence the advice to invest it all now.
What this advice does not consider though is the downside and your tolerance for risk. Just because something is right most of the time, doesn’t make it right all the time.
If you decide to dollar cost average, you may get negative comments from a lump sum proponent along the lines of “you are trying to time to the market”. That is not what dollar cost averaging is about at all though. You should use dollar cost averaging because you want to minimise the risk of losing money, and you are OK with the potential of missing out on some extra gains.
Yes, the odds of smaller gains are greater with dollar cost averaging, but the odds of smaller losses are also greater. What type of investor you are should determine your decision.
Three examples
We will use the historical NZ stock market as an example, starting with the period 2003. If we have $50,000 to invest, we can either invest it all now (lump sum) or invest some each month (dollar cost averaging). In these examples we will use $2,777.78 per month for 18 months as our dollar cost averaging strategy. How much will both strategies have, with no further investments, at the end of 2018 (15 years)?.
Lump sum – $171,400
Dollar cost average - $150,156
The invest it all now investor would have been $21,000 better off than the invest it slowly over 18 months investor. No chump change indeed, and the reason lump sum investors are so passionate about their thoughts. Sitting on the sidelines can prove very costly indeed.
But……… what if we came across this lump sum of $50,000 in 1993, instead of 2003. Using the same numbers, how much would we have had under each strategy after 15 years?
Lump sum – $62,090
Dollar cost average - $67,713.
$5,500 better off using the dollar cost averaging strategy, due to the fact there was a 12.4% drop in the market the year we started investing.
Finally, what if we follow the same example, but starting in 2008. The year of a 32.8% drop in the market. How much would we have 10 years later in 2017?
Lump sum – $103,900
Dollar cost average - $137,993.
$34,000 less for the lump sum investor.
These examples are for $50,000 remember. The differences could be much more exaggerated with higher or smaller lump sum amounts.
Final Thoughts
Investing a large sum of money at a falling time in the market can prove costly, as can not investing a large sum of money at a rising time in the market.
Because the market rises more often than it falls, lump sum investing will leave you better off MOST of the time.
The key question is how would you feel if the market dropped shortly after investing?
I’ve recently sold my apartment and ended up with a lump sum from the proceeds of the sale. I have gone through this exact decision very recently and decided on dollar cost averaging over the next two years. Sure, it means some money on the sidelines not earning much interest, but it was the best decision for me as it allowed me to sleep comfortably at night. My tolerance for risk is not as high as it was in my single days. Now I have a family to take care of, minimising risk is key for me.
If the market continues to rise over the next couple of years then I would be less well off than if I invested the lump sum. But I feel much better about missing out on some extra gains than I would about losing more if the market started falling. This decision allows me to sleep better at a night, and that is what financial decisions are all about. Yes, there is the mathematical, but you can’t disregard your rational feelings.
If you are not comfortable with such an event, then you may want to consider dollar cost averaging. If you are comfortable with a market drop after investing a lump sum, then lump sum may be the best alternative for you.
Don’t just blindly make the decision based on popular opinion. Your situation is unique. If you are making the decision based on the odds alone, then be very prepared to lose. You are much better basing the decision on your investment goals and risk tolerance, then you can consider the odds.
If you need an investment plan or recommendations , then get in touch today.
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here