Fee Only Financial Planning

Lump-Sum Investing vs. Dollar-Cost Averaging

Some investors favor a dollar-cost averaging (DCA) approach to deploying their
investment capital. Unlike lump-sum investing, in which the full amount of available
capital is invested up front, DCA spreads out investment contributions using installments
over time. The appeal of DCA is the perception that it helps investors “diversify” the cost
of entry into the market, buying shares at prices that fall somewhere between the highs
and lows of a fuctuating market. So what are the implications of DCA for investors
aiming to generate long-term wealth?

 

ENTRY LEVEL

Let’s take the hypothetical example of an investor with $12,000 in cash earmarked for
investment in stocks. Instead of buying $12,000 in stocks today, an investor going the
DCA route buys $1,000 worth of stocks each month for the next 12 months. If the market
increases in value each month during this period, the DCA investor will pay a higher price
on average than if investing all up front. If the market decreases steadily over the next 12
months, the opposite will be true.

While investors may focus on the prices paid for these installments, it’s important to
remember that, unlike with the lump-sum approach, a meaningful portion of the
investor’s capital is remaining in cash rather than gaining exposure to the stock market.
During the process of capital deployment in this hypothetical example, half of the
investable assets on average are forfeiting the higher expected returns of the stock
market. For investors with the goal of accumulating wealth, this is potentially a big
opportunity cost.

Despite the drawbacks of dollar-cost averaging, some may be hesitant to plunk down all
their investable money at once. If markets have recently hit all-time highs, investors may
wonder whether they have already missed the best returns and so ought to wait for a
pullback before getting into the market. Conversely, if stocks have just fallen and news
reports suggest more declines could be on the way, some investors might take that as a
signal waiting to buy is the wiser course. Driving the similar reactions to these very
different scenarios is one fear: what if I make an investment today and the price goes
down tomorrow?

 

Financial Advisor Asheville Woodstone

 

Exhibit 1 puts those fears in a broader context. It shows the average annualized
compound returns of the S&P 500 from 1926–2019. After the index has hit all-time highs,
the subsequent one-, three-, and fve-year returns are positive, on average. After the S&P
500 has fallen more than 10%, the subsequent one-, three-, and fve-year returns are also
positive, on average. Both data sets show returns that outperform those of one-month
Treasury bills. Overall, the data do not support that recent market performance should
infuence the timing of investing in stocks.

 

DIFFERENT STROKES

Both theory and data suggest that lump-sum investing is the more effcient approach to
building wealth over time. But dollar-cost averaging may be a reasonable strategy for
investors who might otherwise decide to stay out of the market altogether due to fears
of a large downturn after investing a lump sum.
The stock market has offered a high average return historically, and it can be an
important ally in helping investors reach their goals. Getting capital into stocks, whether
gradually or all at once, puts the holder in position to reap the potential benefts. A
trusted fnancial advisor can help investors decide which approach—lump-sum investing
or dollar-cost averaging—is better for them. What’s clear is that markets have rewarded
investors over time. Whichever method one pursues, the goal is the same: developing a
plan and sticking with it.

 

 

 

 

 

 

 

 

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Woodstone Financial, LLC is a fee-only financial advisor, specializing in retirement planning, comprehensive financial planning, and investment management firm located in Asheville, North Carolina.   Contact us to learn more about our services.