If you have a regular income, such as a monthly salary, the dollar-cost averaging (DCA) strategy suits you well. You can regularly invest as soon as you earn your monthly salary. But if you already have a sizable amount of money idle in your bank account, should you invest this capital over an extended period or in one lump sum investment? Which is more suitable in this case: dollar cost averaging vs lump sum?
What is Dollar Cost Averaging?
Instead of investing your whole capital in one go, you split them into several roughly equal parts and invest them separately over a more extended period. You spread your investment over a long time by making regular smaller investments. Typically you can make these investments every month or quarter.
Let’s see an example: Suppose you have $8,000 to invest. You can split them into eight investments of $1,000 each and invest them for the next eight months.
Amount invested | Unit price | Units bought | |
---|---|---|---|
January | $1,000 | $10 | 100 |
February | $1,000 | $14 | 71.43 |
March | $1,000 | $9 | 111.11 |
April | $1,000 | $13.5 | 74.07 |
May | $1,000 | $8 | 125 |
June | $1,000 | $8.5 | 117.65 |
July | $1,000 | $7.5 | 133.33 |
August | $1,000 | $10 | 100 |
Total bought | 832.59 |
If you invest the whole $8,000 immediately, you will get 800 units. However, if you invest it over the next eight months, you end up with 832 units. Of course, if you invest everything in July, you will get the highest number of units.
Here comes the main benefit of the dollar cost averaging vs lump sum: it minimizes the impact of market volatility. By making regular investments, you ensure you continue investing regardless of whether the market is up or down.
Pros and cons of dollar-cost averaging
Pros of dollar-cost averaging | Cons of dollar-cost averaging |
---|---|
Minimize market volatility impact
By investing regularly over a longer term, you invest through the ups and downs of the market. |
Slower entry point could mean lower growth
Because you do not immediately put in the initial capital, you may lose the potential compound effect on your idle uninvested amount. The longer the delay, the more the lump sum usually outperforms dollar-cost averaging due to this compounding effect. |
Avoid the temptation to try timing the market
Timing the market is challenging, and you may make poor investing decisions. Instead, you can just invest regularly over the long term. |
Higher fees
Your brokerage usually charges fees for every transaction. By splitting into several transactions, you will be paying more brokerage fees. |
More flexibility
Even though you are supposed to invest consistently every month/quarter, you have the flexibility should there be an urgent need to deviate from your original plan. |
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Start with smaller capital
Dollar-cost averaging means you can start with smaller initial capital and invest it immediately. |
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Learning process
With a smaller investment amount, you can use it to make the first step, learn, and build confidence in your investing journey. |
Who is dollar-cost averaging suitable for?
DCA is an excellent strategy for investors with regular income who want to invest in the market. If you have a monthly salary, you can DCA every month as soon as you receive your paycheck. This strategy is also suitable for those who want to be more ‘passive’ with their investing style without getting too involved with the market. You can just ‘buy and forget.’
Who is dollar-cost averaging not suitable for?
DCA strategy is not ideal for investors with a decent amount of capital idle in their bank account. Instead of spreading your investment over a long period, you generally want to invest faster to enjoy the compounding effect.
What is Lump Sum Investing?
With this strategy, you invest your whole capital in one go. In our example above, you invest $8,000 immediately in January. By investing in one go, you can immediately enjoy the compounding effect on your entire invested capital.
Pros and cons of lump sum investing
Pros of lump sum investing | Cons of lump sum investing |
---|---|
Longer investing horizon for the compounding effect
By investing faster, you can enjoy a longer timeframe for the compounding effect on your entire capital. |
Higher short-term risk
You are exposed to the possibility of investing before the market downturn, thus incurring short-term losses. But over the long term, the market tends to increase; therefore, it is considered a short-term risk. |
Lower fees
Because you make just one investment, you only need to pay fees on that transaction. |
Less flexibility
Once you invest the capital, it will be harder to reaccess it. Make sure the money does not come from your emergency fund. |
Who is lump sum investing suitable for?
This strategy is ideal for investors with sizable idle capital ready to invest. Instead of leaving your cash idle, you can fast-track your investment by investing the whole capital in one go and immediately letting the compounding effect take place on your entire capital.
Who is lump sum investing not suitable for?
The main risk of lump sum investing is the risk of investing right before a market downturn, thus exposing you to immediate unrealized losses on your investment. If you are a risk-averse investor, this strategy may not suit you due to the high exposure to market volatility.
Dollar cost averaging vs lump sum: Which is better?
Which strategy is better, dollar cost averaging vs lump sum, depends on the circumstances of the investors. Each strategy has its pros and cons.
If you have a sizable idle amount of money to invest, investing it in one lump sum investment would be beneficial so that you can fast-track your investment portfolio. In terms of performance, you will likely benefit from investing in a lump sum over dollar-cost averaging because you start enjoying the compounding effect on your entire capital immediately.
However, if you don’t have a lot of capital to invest but have a regular income, dollar-cost averaging is an excellent strategy you can adopt. It lets you put your money to work immediately after receiving your salary. You can automate this regular investing so that you don’t have to worry about the state of the market.
With everything said above, if you have both a sizable amount of idle cash to invest and a regular salary, you can do both: invest your idle capital immediately in one lump sum investment and continue to dollar-cost average with your monthly salary.
FAQs
I have a significant amount of cash to invest. I believe I should make a lump sum investment, but I don’t feel comfortable investing a substantial amount in one go. What should I do?
Risk tolerance is an essential part of investing. If you are uncomfortable doing a lump sum, you can do dollar-cost averaging with a shorter timeframe. For example, you can do DCA over 6-12 months. This way, you can have the middle ground between both strategies. You don’t delay the investment for too long and simultaneously reduce the risk of short-term market volatility.
How often should I dollar-cost average?
It depends on your preferences. Most people do monthly or quarterly. If you earn a regular monthly income, you can also follow the monthly schedule for your investment. You can invest a portion of your salary as soon as you receive it. You can do this manually or automate it using a regular saving plan.
If I make a lump sum investment and the market drops afterward, I will lose a lot of money. Isn’t this bad?
Losing money is not a pleasant experience. But remember that you do not lose the money until you realize that loss by selling your investment. Our general advice is to invest only in appreciating assets. We invest for the long term, and these assets will likely increase in value in the long run. Before investing, please ensure you have a long enough investment horizon to weather short-term market volatility comfortably.
I rarely meet people who make lump-sum investments. Am I missing something?
Well, that’s normal because most people earn their income through their monthly salary. In this case, they will do dollar-cost averaging monthly with their monthly income. However, in some cases, investors may also receive a sizable amount of money from other sources, such as inheritance, selling business, lottery, etc. For this extra liquidity, a lump sum investment may be appropriate.