Lump Sum Investing vs Dollar Cost Averaging: Which Should You Do?

Dollar cost averaging is an investing strategy in which you invest a fixed amount of money at regular intervals regardless of the price of the underlying asset. For example, you might invest $500 each month into an S&P 500 index fund regardless of what the price is.

This strategy allows you to buy more shares when the price of the asset is cheaper and less shares when the price of the asset is more expensive. Dollar cost averaging can help take the emotion out of investing as you simply stick to the strategy over the long haul no matter what is happening in the markets.

Lump sum investing on the other hand is when you invest a lump sum of money all at one time. For example, maybe your rich uncle passed away and left you $100,000. Instead of breaking up this sum into monthly investments, you would simply invest the $100,000 all at once.

In general, the math supports lump sum investing over dollar cost averaging for one simple reason - time in the market. The more time that money sits in the market, the possibility that compound interest grows that money over time increases.

For example, if you invested $100,000 at the beginning of the year into the stock market that entire $100,000 would have the chance to grow as opposed to dollar cost averaging a smaller amount each month. A study by Vanguard proves this point further.

Vanguard looked at a portfolio with a 60/40 split between stocks and bonds respectively and analyzed if lump sum investing or dollar cost averaging would be better. Vanguard looked at 10 year rolling periods in US, UK, and Australian markets.

Over a period of one year lump sum investing outperformed dollar cost averaging 67% or two thirds of the time. Additionally, Vanguard found that this percentage increased with longer time horizons. For example, over a 36 month period, lump sum investing outperformed dollar cost averaging 90% of the time.

This study shows that from a pure mathematical approach, lump sum investing is better than dollar cost averaging. You have a 67% chance of winning with lump sum investing over the course of the year and an even greater chance of winning with lump sum investing over longer periods of time.

However, like all investing strategies, lump sum investing is not going to be perfect. The risk you run with lump sum investing is that the market crashes just after you put your money in. For example, say that you invest $100,000 into the market in January.

In February the market starts to crash and throughout the remaining months of the year, your portfolio goes down in value by 20% meaning you only have $80,000 at the end of the year. If you would have spread out your investments each month by using dollar cost averaging, you would have been able to consistently buy more shares each month since the price of the shares were cheaper.

When the market goes back up, you would make more money as you would have bought more shares when the market was down. However, timing the market is nearly impossible even for professionals. The study from Vanguard shows that it is usually better to invest a lump sum if you are able to.

Additionally, the advantages of dollar cost averaging go away when the market is going up. It is better to have a lump sum invested when the market is on an upward trajectory as you have more money invested which means you will make more money.

As discussed above, the math shows that lump sum investing is better than dollar cost averaging. However, success in personal finance does not always come down to math. There is also a behavioral element to it.
A dollar cost averaging strategy prevents you from being 100% right or 100% wrong.

Here is the rule of thumb. During uptrends in the market, it is always better to have a lump sum invested. During downturns in the market, a dollar cost averaging strategy may be better as you get to buy more shares with a fixed amount of money as the cost of those shares have gone down.
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The risk with lump sum investing is that you may put your money in the market and then the market tanks. From a psychological perspective, this can discourage you from continuing to invest as your portfolio may go down significantly.

As discussed before, it is almost impossible to time the market so if you lump sum, you always have the risk that the market goes down significantly at the wrong time. Of course this money will recover as the market has more up years then it does down, but it can reduce your fervor for investing if your portfolio tanks 20% in a single year.
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On the other hand, if you were to consistently dollar cost average $500 per month over 5 years, there is a good chance that your portfolio will have gone up in value. Simply seeing a dollar cost averaging strategy work can help you continue to invest.

Arguably the most important factor to wealth creation is to stay consistent with your investments. Wealth is built over time and a dollar cost averaging strategy can help you automate your wealth building as the strategy allows you to reduce the emotions that inevitably come with investing.

If you are a more logical investor who likes to make decisions with facts, lump sum investing is a much better strategy as the Vanguard study shows. However, if you are worried about the emotional aspects of investing and want a strategy that will help you stay disciplined, dollar cost averaging may be better from a behavioral, but not a mathematical view.

Regardless of what strategy you use, it is important to diversify your investments. Diversification is simply the idea that you should not put all of your eggs in one basket. You can diversify among industries, market cap (size of companies), geographical location (foreign or domestic investments), asset classes, and more.

The reason that this is a good idea is that it will reduce your overall risk. The reality is that all investing carries risk and there is no way to eliminate it completely, but you can manage it. If you lump sum or dollar cost average all of your money into a single investment, your performance will be based solely on that single investment.

For example, say you put all of your money in Tesla. When Tesla stock is up, you are doing well. However, when the stock is down, your entire portfolio is down as all you own is Tesla. By diversifying, you spread your risk out so that when one asset is not doing well, you own another that can offset that negative performance of the first asset.

A diversified portfolio should not only hold a mix of assets, but it should also align with your risk tolerance (how much risk you are willing to take when you invest). If you have a high risk tolerance, you might invest a greater percent of your portfolio in stocks and less in bonds, and do the opposite if you have a low risk tolerance.

A big part of personal finance is resource allocation. In other words, if you have limited dollars, what is the best use of those dollars? Investing is a vital part of a well rounded financial plan, but there are other components to it as well.

Before investing a lump sum, ask yourself a simple question. Is the best use of my dollars to invest it all or should I use some of these dollars in other areas. For example, say that you recently inherited $100,000 from a relative that passed away.

You are trying to decide what to do with the money. You know that it is important to invest so you want to send some of the dollars towards investing. However, say that you also have other financial goals such as saving for a house and debt management.

Instead of investing the entire $100,000 you could save some of it to use on a down payment for a starter home. You may also be one of the many Americans who has credit card debt. Say that you have $10,000 worth of credit card debt which is a true debt.

Since the interest rates on credit cards are higher than what your investments could earn, it would be smart to take $10,000 of your $100,000 inheritance and pay off your credit cards. You then might take $50,000 and use it as a down payment for a starter home.

You could then lump sum invest the remaining $40,000 as we know that lump sum investing is better than dollar cost averaging from a mathematical perspective. The point here is that it is important to make sure that you are getting the best use out of every dollar you have, including with a lump sum of money.

At the end of the day, do not become a victim of paralysis by analysis. What this means is don't overthink the problem so much that you struggle to make a decision. Both lump sum investing and dollar cost averaging can be used to build wealth in the long term.

As emphasized throughout this article, lump sum investing will make you more money than dollar cost averaging according to the study by Vanguard. If you are simply after the best possible chance to grow your money and trust that the math works it is best to go with lump sum investing.

However, if you want a strategy that will help you develop the behavior of a long term investor, dollar cost averaging is better. Both strategies have advantages and disadvantages, so you have to pick the one that you believe will give you the best chance of reaching your goals.

The bottom line is that dollar cost averaging is an investing strategy in which you invest a fixed amount of money at regular intervals regardless of the price of the underlying asset. Lump sum investing on the other hand is where you invest a lump sum of money all at once.

From a mathematical perspective lump sum investing is better although you do run the risk the market tanks after you invest. Dollar cost averaging is better from a behavioral perspective, but the math shows you will not make as much money and it is more advantageous when the market is down.

At the end of the day, you have to pick the strategy that is best for you. Figuring this out can be tricky as you have to consider your goals, your risk tolerance, your other financial needs, and more. Working with a financial advisor can be a good idea if you want more help than the general information discussed throughout this article.