Say you've got a chunk of money you want to invest.
Is it better to put it to work in the market all at once or to buy gradually over time?
I'm Cameron May and this is Comment Below. Brandon Low commented, Great content. Hey,
thanks Bandon. I hope you can do a video comparing dollar-cost averaging and lump-sum
investing. Which are better performers in the long run?
Well, Brandon, the debate between dollar-cost averaging and lump-sum
investing is a long one. Let's look at each side.
Dollar-cost averaging is continuously investing the same amount of money in a security over time,
regardless of fluctuating prices, rather than the entire amount all at once.
For example, if you wanted to invest $1,000 in shares of a stock that's currently trading
at $50 per share, you could break it into five increments of $200 to purchase shares
at regular intervals. Let's say you were able to purchase shares at $50, $48, $47, $51, and $52
over a period of time. Your average price per share would be $49.60. On average, this saves you
forty cents per share compared to the $50 initial stock price if you had bought it all at once.
There are couple of benefits to this. First, you have a psychological benefit of not risking
the entire amount immediately and having the anxiety associated with the stock falling.
Second, if the stock falls after your first purchase,
you're only losing on a small amount, and the pain is less.
Third, as you saw with the example, buying over time
could bring down your average cost per share if the stock drops.
However, there are risks. If the stock price rises over time, you're buying at a higher price,
which will increase your average price per share. Not to mention missing out on possible gains if
you'd invested the full amount at the beginning. Of course, if the stock price falls over time,
you'll keep buying at lower prices, but there's no guarantee the stock will go back up.
Also, investors who practice frequent dollar-cost averaging may generate additional trading costs,
commissions, and other transaction costs that outweigh any cost benefit.
Another approach is lump-sum investing, which is the immediate investment into
a security using all available funds. So, going back to the earlier example,
it'd mean investing the full $1,000 at once for $50 per share.
If the stock rises, you're all in, and you get all the benefits.
If the stock falls, you're all in, and you get all the losses.
Over the years, investors and scholars have studied these strategies with mixed results.
The winning strategy varied based on factors like time frame, whether the results were adjusted for
risk, and how performance was measured. For example, check out this chart from
a 2020 study, which compares the performance of dollar-cost averaging versus lump-sum investing
over time. When the line is above the zero level, dollar-cost averaging is outperforming
lump-sum investing. When the line is below the zero level, lump sum is outperforming.
So, either strategy may outperform at a given time. Because the line spends more time under
the zero level, lump sum is more often the winner. However, this chart doesn't account
for the risk associated with each strategy. Let's look at the standard deviation of returns
for the two strategies. Standard deviation, defined as a measurement of the average
absolute deviation from the mean, is a measure of volatility or risk. The chart shows that lump-sum
investing has greater volatility, which means it has greater risk than dollar-cost averaging.
So, what does this all mean? First,
which strategy is the best will depend on market conditions. Not surprisingly,
lump-sum investing has historically performed better during bull markets than bear markets.
Second, the better strategy depends on your risk tolerance.
If you forecast a bull market and you have a higher risk tolerance,
lump-sum investing is likely the better choice. However, if you're forecasting
volatility and you're risk adverse, then dollar-cost averaging may make the most sense.
Of course, dollar-cost averaging is only one way to manage risk in a portfolio.
Lump-sum investors can potentially lower their risk and increase their returns by rebalancing
their portfolios. Rebalancing is the process of selling some of an outperforming asset and using
the proceeds to invest in underperforming assets in order to maintain a preferred investment mix.
For example, let's say you had a 50% stock and a 50% cash portfolio that you rebalanced each month.
Studies have shown that a lump-sum investment with a rebalancing strategy
outperformed both dollar-cost averaging and lump-sum investing without rebalancing by
creating greater returns with lower risk. Perhaps, the bigger lesson to be learned
is that investing often comes down to managing risk, and to do that,
you need to consider your whole portfolio. Dollar-cost averaging allows you to manage
some risk on entry, but lump-sum investing plus portfolio management strategies like rebalancing
may provide the best of both worlds: putting money to work more quickly
along with risk management throughout the lifetime of your investments. Regardless of which approach
you choose, be aware of your risk tolerance and be intentional about your strategy for managing risk.
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