Dollar Cost Average vs. Lump Sum Investing

Today, there are so many ways to invest your money that the number of options available to you can be overwhelming. But in order to make that kind of decision effectively, you need to be aware of a number of fundamental distinctions when it comes to the way in which money is invested. 

One of these is the difference between dollar-cost averaging and lump sum investing. Each of these approaches has advantages and disadvantages, and this makes them suited to particular types of investor. 

In this article, we’ll take a look at the key differences between dollar cost averaging and lump sum investing, so you can make up your mind as to which is best for you.

The Basics

First, the basics. At the most basic level, the difference between these two approaches can be explained very simply.

With dollar cost averaging, you invest your money over a period of time, in a number of smaller payments. With lump sum investing, you put all of your money behind a particular investment right away.

Let’s say you have $12,000 to invest, and you want to use it to buy stock. A dollar cost averaging approach would be to buy $1,000 worth of stock every month for a year.

The lump-sum approach would be to put $12,000 into the investment immediately. 

Once you understand this principle, you’ll start to see examples everywhere. The pension that most of us have at work, for instance, is a classic example of dollar cost averaging, because you are buying into an investment (or, more likely, a range of investments) very slowly, over the course of your whole career.

In contrast, buying stock in a company you think will realize short-term gains is a lump-sum investment.

Behind this seemingly simple difference lies much complexity, however. And with that in mind, let’s take a closer look at the two types of investing in more detail.

Dollar Cost Averaging

The principle of dollar cost averaging is straightforward, as we’ve discussed above. With this approach, you invest your money in a number of steps, spread out over months or years.

At first glance, it might seem like this approach would leave you in much the same position as investing the same amount of money all at once. In practice, however, that’s not the case. 

To see why, let’s return to our example above, where we are investing $12,000 in stocks. These stocks will be changing their value all the time – that’s why they may be a good investment.

However, with highly volatile stocks it can be difficult to ascertain their true value, even if you are certain that this will increase over time.

In this situation, lump-sum investing is risky, because you could put your money into the stock just as it reaches a short- to medium-term peak in value.

If that’s the case, you’ll see your investment decrease in value for many months before it finally picks up again. 

This is where dollar cost averaging comes in. By spreading your investment over a large number of small tranches, you are more likely to invest at the actual (the average) cost of the share.

This makes it very unlikely that you will pay more for stock than it is worth in the short- to medium-term.

Lump-Sum Investing

Given the advantages of dollar cost averaging, it can seem like lump sum investing is always a losing strategy. That’s not the case, though. 

The reason for this is simple. By putting more of your money into an investment as early as possible, you stand to make the maximum possible return should it increase in value.

Experienced investors know the value of compound interest and compound gains, and these are maximized if you put a significant sum into an investment as soon as you are able to.

On the other hand you should be aware that lump-sum investing is a strategy that requires a high level of risk tolerance.

If you have $20,000 to invest, a lump sum investing strategy would tell you to dump all of that money into your investments at once. By doing that, you run the risk that the stock market can tank immediately (just like what happened in March due to the coronavirus pandemic).

Interesting Read: Coronavirus: What Does It Imply For Your Investment?

Alternatively, it can go upward and you win out – hence the reason it’s a gamble.

Which to Choose?

As we’ve seen, both dollar cost averaging and lump sum investing have advantages and disadvantages. These, in turn, mean that they are suited to different types of investors.

Dollar-cost averaging works really well for nervous investors with lower risk tolerance and who have larger sums of money sitting around in something like a high-yield savings account.

You can minimize your risk by spreading out your investment into smaller chunks, while still keeping cash in a safer investment.

On the other hand, if you want to see the maximum possible gains and can tolerate a relatively high level of risk, lump-sum investing is likely to be a better choice for you. 

In practice, most investors will opt for a mixed strategy, where they invest steadily in favored stocks and funds, and occasionally take a gamble on a company or instrument that they think will increase in value.

And there is nothing wrong with this – you should just be careful to include enough dollar cost averaging in your investment strategy to keep your risk tolerably low.