Lump-sum investing comes with higher risk accompanied by the potential for higher returns, while dollar-cost averaging limits your overall risk and may deliver more conservative returns. Each has its benefits, and the best option for you will depend on your investment objective.
What’s the Difference Between Dollar-Cost Averaging and Lump-Sum Investing?
Lump-sum investing, on the other hand, is investing all your money at once. Rather than spreading out your buy orders over time, you would take the full $25,000 and invest it upfront at the most optimal time.
Risk and Reward
As the saying goes, “High risk, high reward; low risk, low reward.” Dollar-cost averaging is a strategy often used to help manage risk exposure, which usually also leads to more conservative returns as compared with the potential returns of lump-sum investing. By scheduling out your investments to be processed over a period of time, you are limiting your losses should the market take an unexpected nosedive. This is possible because you didn’t invest your money all at once. In fact, you may be lowering your average purchase price because you have upcoming scheduled investments that will be processed at potentially lower prices. While you may be lowering your overall risk by dollar-cost averaging, you may be losing out on overall return potential. When you might have invested all your money at the market bottom, you only invest little by little, so only the amount invested at the market bottom will get the high returns. When you invest all your money at once, you immediately get full exposure to market growth (or decline). Let’s say you have $25,000 to invest and decide to invest it all at once into a Standard & Poor’s 500 index fund. During the next six months, the stock market rises by 10%, which means your whole portfolio also grows by 10%. Had you invested only moderate amounts rather than a lump sum during this six-month market growth period, you would have a lower expected return because only part of the $25,000 is exposed to that total 10% growth. However, the contrary is also true. If you invest $25,000 in an S&P 500 index fund, the market could tank 10% in the next six months, resulting in larger losses than experienced by the dollar-cost averaging investor.
Price Per Share
When you make scheduled investments regardless of current economic conditions, you will likely buy more shares when prices are low and fewer when prices are high. For example, if you invest $25,000 over 10 months without concern for market conditions, you will buy in at many different price points. When averaged out, your price per share may turn out to be much lower than if you tried to pick the optimal price and invested your money all at once. If you invest the full $25,000 at once, your price per share is dependent on the current market conditions at the time of making the investment purchase.
Special Considerations
Keep in mind that when following a dollar-cost averaging strategy, you are not avoiding market loss and may be forgoing potential returns at the cost of lower risk. Depending on the type of investment purchase, keep in mind that you may pay more brokerage fees overall with dollar-cost averaging because you are making multiple purchases, rather than a single lump-sum purchase.
Dollar-Cost Averaging vs. Lump-Sum Investing Example
Mark the investor has $12,000 available to invest. He is exploring his options and has decided to put it into an S&P 500 index exchange-traded fund (ETF). Mark has two choices: He can invest it all at once and buy $12,000 worth of ETF shares today, or he can invest $2,000 per month for six months. Here is a hypothetical example of each scenario. If Mark invests the full $12,000 upfront, his purchase price per share would be $100 for a total of 120 shares. This is an example of lump-sum investing. See the table below for details.
Which Is Right for You?
Dollar-cost averaging may best suit investors who:
Want to take emotion out of investing and avoid timing the market Wish to limit their market risk over time Want to possibly lower their average price per share Have little investing experience
Lump-sum investing may best suit investors who:
Don’t let emotions determine their investment decisions Have a higher risk tolerance Seek to achieve the highest potential returns Have experience researching investments and determining the optimal buying price
The Bottom Line
Dollar-cost averaging is investing equal amounts of money on a regular basis, regardless of market conditions. It is an investment strategy widely used to remove emotion from investing, lower average price per share, and limit market risk by spreading it out over a period of time. Lump-sum investing occurs when investors put in all their money for a stock purchase at once. They are often trying to time the market and buy at the optimal price for maximum potential profit. Lump-sum investing comes with more risk but often can promise higher potential returns. The goal of investing is to “buy low, sell high.” Deciding when is the best time to buy is a tough task to tackle. Choosing which option is right for you will depend on your risk tolerance, investment objective, and overall investment experience.
