Dollar Cost Averaging vs Lump Sum Investing   Leave a comment

You can find many articles and blog posts on dollar cost averaging vs lump sum investing. This discussion is only relevant when you have a large lump sum that you want to invest, which generally occurs either when you are starting investing, or you receive a windfall from say an inheritance.

Lump sum investing – You invest the entire lump sum according to your Investment Policy Statement (IPS).

Dollar cost averaging – You invest your lump sum over a period of time, typically 6-12 months.

In the absence of a lump sum, people who invest typically end up using dollar cost averaging, simply because they get their paycheck on a regular basis and have 401k contributions deducted from their paycheck. However, with lump sums, you are presented with this choice.

The mathematically optimal solution is to just use lump sum investing. Studies have shown that about 2/3 of the time, you are better off lump sum investing. This is because on average, the stock and bond markets trend upwards in the long run (and if they didn’t you wouldn’t be investing in the first place).

However, the psychological factor comes into play here. Many people are afraid of “losing” a lot of money shortly after their investment. Which can certainly happen – it seems a major stock crash happens every 10-15 years (though this is not something you shoudl try to predict with any kind of certainty).

Now to alleviate some of your concerns about lump sum investing, I will remind you about the story of Bob, the world’s worst market timer. Bob only invested lump sums right before four major market crashes, but despite his bad luck he ended up with $1.1 million in 2013 for a total of $184,000 invested (note that the $1.1M is in 2013 dollars, whereas the $184,000 is not inflation adjusted investments from 1972 to 2007). The only reason this went so well for him is because he never panicked and sold.

So even if you “lose” a lot of money with a lump sum investment, you will still do just fine as long as you stick to your IPS and do not panic and sell.

But despite all this, if you are scared to make a lump sum investment, dollar cost averaging is certainly better than not investing at all! Dollar cost averaging is most effective if you invest about half of your lump sum immediately, and then invest the rest in equal increments over the next 6-12 months. Don’t dollar cost average over too long a period, because the overall long term trend of the stock and bond markets to rise over time will tend to dominate.

The psychological factor in investing is important and cannot be ignored. I faced this decision when I started investing, and in the end I just ended up investing the lump sum all at once. I did this because I knew that rationally, it was the best choice with the information given at the time. But that may not work for everybody. Whichever option you choose, make you sure you choose one! (Proper index) investing is better than not investing at all!


Posted January 28, 2015 by Fiby in Uncategorized

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