Today, Amy and Jag delve into the contrasting strategies of lump sum investing versus dollar-cost averaging (DCA). Amy starts by defining lump sum investing as the practice of investing a large amount of money all at once, like a $100,000 bonus, while dollar-cost averaging involves spreading the investment over time, such as $10,000 a month for ten months.
Amy explains that dollar-cost averaging helps mitigate risk by buying more shares when prices are low and fewer when prices are high, thereby balancing the overall cost. This strategy is particularly useful for those wary of market volatility. On the other hand, lump sum investing can yield higher returns as it gets the money working in the market immediately, a point backed by research from Vanguard which shows that lump sum investing outperforms DCA 68% of the time over one-year and ten-year periods.
We discuss why an investor might choose one strategy over the other. Lump sum investing offers simplicity and higher potential returns but comes with the risk of market downturns right after the investment. Dollar-cost averaging, while potentially yielding lower returns, reduces this risk and provides psychological comfort, preventing panic in the face of market drops.
Jag and his wife employ both strategies. She invests consistently each month through her 401(k), embodying dollar-cost averaging, while Jag, as a self-employed individual, saves throughout the year and make a lump sum investment into his SEP IRA at year’s end.
Market conditions also play a significant role in choosing a strategy. In a bull market, lump sum investing tends to perform better as the market is generally rising. During volatile or bear markets, dollar-cost averaging can be advantageous as it allows investors to benefit from lower prices over time.
Amy highlights historical performance, noting that lump sum investing generally yields more over a 10-year period, with 66-67% success across various markets like the US, UK, and Australia. However, risk-averse investors, or those who need time to adjust psychologically to seeing their cash reserves drop significantly, might prefer dollar-cost averaging.
Practical tips for deciding between these strategies include assessing personal risk tolerance, considering one’s financial situation and goals, avoiding market timing, and seeking professional advice. The key takeaway is that there’s no absolute right or wrong choice between lump sum investing and dollar-cost averaging. The best decision is the one that aligns with personal comfort and long-term financial objectives.
For further advice, listeners can reach out to Amy and her team at Thimbleberry Financial via their website or phone. It’s important to remember that investing should always be approached with a long-term focus and in consultation with financial professionals
ThimbleberryU 118 - Lump Sum Investing vs Dollar Cost Averaging
Jon Gay (00:03):
Welcome back to ThimbleberryU, I'm Jon Jag Gay. I’m joined as always by Amy Walls from Thimbleberry Financial. Amy, pleasure as always to be with you.
Amy Walls (00:10):
Jag, it's great to talk to you.
Jon Gay (00:11):
So, you may have heard the term “dollar-cost averaging or dollar-cost average investing” as opposed to “lump sum investing.” We're going to kind of break down these two different strategies today. Let's start with the basics: explain what is lump sum investing versus dollar-cost averaging.
Amy Walls (00:26):
Lump sum investing is the idea, or the practice really, of taking a larger amount of money and putting it all into an investment at one time. So, for example, if you were to receive a big bonus and let's say, it's a hundred thousand dollars after taxes.
Jon Gay (00:47):
Nice even number.
Amy Walls (00:49):
You take it and say, okay, tomorrow this is all getting invested. So, it happens all at once.
If we contrast that with dollar-cost averaging and we use this hundred thousand dollars that was received in a bonus, maybe you invest $10,000 a month for 10 months, to get that money invested. So, with dollar-cost averaging, we're spreading the investment out over a period of time. Now, I imagine the next question is, why would you do this?
Dollar-cost averaging essentially allows you to buy more shares when prices are low, and then you buy fewer shares when the prices are high. And so, that overall, it balances out.
Jon Gay (01:30):
Okay, so with the dollar-cost averaging, you're investing the same amount every month. So, that same dollar amount gets you more shares when it's low, gets you less shares when it's high. Got it.
Amy Walls (01:40):
Yes. Essentially, you're diversifying your timeframes since you don't know if when you put money in, is going to be high or low.
Jon Gay (01:48):
Okay, so my next question, you can probably anticipate: why would someone choose lump sum or dollar-cost averaging?
Amy Walls (01:54):
There are different benefits to each one, obviously. So, benefits of lump sum investing are a higher potential return. So, Vanguard has done some research on this as has some other companies. And the research shows that lump sum investing outperforms dollar-cost averaging about 68% of the time.
Jon Gay (02:14):
So, two thirds?
Amy Walls (02:15):
Over one-year periods and 10-year periods. And the idea is that it gets your money working in the market immediately. It's also simple, it's a straightforward approach. You do it once; you forget about it.
Now, there's benefits to dollar-cost averaging also. Biggest one is risk mitigation. So, by spreading out when you invest, you reduce the risk of investing a large amount just before a market downturn.
So, in the example we used earlier, if I put in a hundred thousand dollars tomorrow and the next day the market drops, I may kick myself because my hundred thousand immediately became $70,000. If whatever investments went down 30%. So, that's why dollar-cost averaging is helpful. It mitigates that risk.
The other thing is behavioral comfort, and it ties in with the example I just gave. It mitigates the fear of making a big investment decision, which may be uncomfortable. And all of that can lead to better decision making in the future.
So, we sometimes talk about the psychology. If I invest a hundred thousand dollars tomorrow and the next day, it becomes $70,000, do I understand that I invested this for the long term, and it's a blip, it'll come back, it should come back assuming it's market conditions versus just picking a very poor investment.
Or am I going to look at that and say, “Oh no!” And the story I tell myself is I lost $30,000. I should not do this. And so, in the future when I think about investing, I'm always going to repeat that I made that mistake and not want to invest.
Jon Gay (04:00):
So, that is the real risk with lump sum investing. You mentioned the Vanguard study that shows two thirds of the time lump sum investing does come out ahead. But it sounds like you're getting to the answer to my next question, which is why would someone still choose dollar-cost averaging? A lot of that is the psychology, I imagine.
Amy Walls (04:16):
It absolutely is the psychology. Those stories we tell ourself (quoting Brene Brown on “those stories”), they're powerful. We attach to them. It's a form of anchoring bias, and confirmation bias: “I made this mistake; therefore, it's going to happen again. Going to do these things.” So, that's daunting and stressful.
And so, if somebody who we know is going to do that or has an inclination to think that way or remember it that way, we would want to choose dollar-cost averaging so that we can succeed in the future.
Jon Gay (04:50):
So, full disclosure, my wife and I actually do both. My wife is a W2 employee, so her money goes into her 401(k) and her taxes every month. And we do our finances every month and we give some to our financial advisor to invest every single month. So, similar to the dollar-cost averaging.
But for me as a solopreneur or self-employed LLC, I put away money for taxes and investments throughout the year. And then at the end of the year, once we've worked with our CPA and our financial advisor in concert, and we see, okay, what's left that I can dump into my SEP as a solopreneur.
So, she's doing the dollar-cost averaging, and I'm doing lump sum investing, so we kind of have the best of both worlds.
Amy Walls (05:29):
Absolutely. And I think that can be a great way to handle that. Many of our clients, whether in tech or in healthcare are dollar-cost averaging as part of their investment strategy.
But then many times, because we know they're going to have tax bills that we want to leave extra cushion for, and that we can't predict perfectly in 12 months in advance, we've left an extra cushion there or stock's going to pay out. And so, we may lump sum invest those dollars all depending on personality. Some of them we still dollar-cost average those extras.
Jon Gay (06:04):
Fair enough. Alright. So, Amy, how do market conditions affect the choice between these strategies?
Amy Walls (06:09):
That's a really great question, Jag. So, in a bull market, when the market's doing well, it's going up, lump sum usually performs better because your money is fully invested and benefiting from market growth.
So, a lot of times when it's going up, that's when people say, “Sure, I want to just put it in now and take advantage of this upturn.” When it's going down or in periods of volatility, meaning where it's bouncing, that's where dollar-cost averaging may be advantageous because it allows you to buy at lower prices if it is going down.
Now, I'll say that, and I think back, my perfect example of this is March 2020. COVID had just hit, the market dropped quite a bit for about a month. We had a number of clients who actually are on the more moderate end rather than aggressive who had extra money who were like, “Wow, this was a quick fast decline. We have cash on the sidelines that we have been dollar-cost averaging. We're happy knowing we're getting in at a 30% decline and we're going to stop our dollar-cost averaging and switch all of that to lump sum.”
Because they said, look, the story we can tell ourselves is we already just gained 30%. And so, we're happy even if it drops further now and it simplifies our lives going forward.
Jon Gay (07:35):
So, you alluded to some of this earlier, Amy; what about the historical performances of these strategies?
Amy Walls (07:39):
So, I mentioned Vanguard did this research. They looked at markets in the U.S., the UK and Australia, and 66 or 67% (just a full and fair disclosure, there's a range of 1%) for each 10-year period. So basically, each decade or I believe they broke it down for all 10-year periods, so it wasn't just decades that they looked at – 66 or 67% of the time, if you lump sum invested, you ended up with more money 10 years later.
Well, in a 10-year period, the market tends to be up most of that time, which is why that would happen. Now, where that may not happen is it was an extra volatile 10 years or there was a big decline right before the 10-year period was up that maybe caused the end value to be lower than what was put in.
Jon Gay (08:37):
Skew the total number at the end. Got it, okay.
Amy Walls (08:39):
Exactly. And the interesting thing to note about this is that's a 10-year period, that's still not a long-term investment timeframe. And so, the further you go out from 10 years, the greater that success rate of having more money, having more than you put in actually increases.
Jon Gay (09:02):
Are there specific type of investors that would prefer either dollar-cost averaging or lump sum investing, one over the other?
Amy Walls (09:09):
Absolutely. Risk averse investors tend to like the dollar-cost averaging more. I'd also say people who like process and consistency.
The other group that this is really good for, is let's say somebody has been sitting on a lot more cash than they need and have been sitting on it for quite some time, and maybe they're going to right size that cash reserve and get money invested – that's a shock to the system when you open the bank account and its half or less than half of what it's been for several years. That's rattling to people no matter what your risk tolerance is. You get used to opening it knowing you have that security. So, a slow adjustment can be very beneficial in that case.
For those that are more comfortable with risk, that are more focused on maximizing returns and can stomach that downturn, they're probably more attuned to the lump sum investing with extra bits of money.
Now, you mentioned your wife investing in her 401(k), dollar-cost averaging, those people still are likely to be doing some dollar-cost averaging and probably should be.
Jon Gay (10:23):
Sure. So, what are some practical tips for someone deciding between these two strategies?
Amy Walls (10:29):
Assess your risk tolerance. Now, that's self-assessment because you may be able to quickly come to a decision based on some of the things we've already talked about.
But maybe talk to people who know you: a partner, a spouse, a best friend. Really, if you're on the fence, they may be able to sway you to the kinds of stories you actually tell yourself. Because I think too often, we are not aware of the stories we tell ourselves.
Consider your situation and your goals. Do you have a big emergency fund? Does your investment decisions and your timeframe for when you're going to need the money that you're putting in, does that sway if you want to make a lump sum investment or dollar-cost average?
Avoid market timing. Now, I use the example of March 2020 earlier. Some people could say that's market timing. And in a way, in a sense it is; it's also opportunity. Market dropped 30%, look, this is a reaction to the COVID announcement. Whether or not this downturn lasts a year, I'm okay with it because I'm not going to need the money and I just gained 30% rather than investing this when it's high.
Jon Gay (11:39):
Buy low, sell high.
Amy Walls (11:40):
Exactly. So, there's logic that's applied to that, but just saying, “I'm going to do this now and put this hundred thousand dollars in because so and so got elected,” that would be much more of market timing.
Jon Gay (11:54):
Got it. And an emotional decision as we talked about in our previous episode as well.
Amy Walls (11:58):
Absolutely. And then getting advice. I don't mean as a financial advisor to tout the use of a financial advisor, but even though I said talk to partner, spouse, best friend, somebody who does this, day in and day out, will be able to help you recognize what might fit you best.
Jon Gay (12:17):
That is key right there. What is our final takeaway for listeners when it comes to lump sum investing versus dollar-cost averaging?
Amy Walls (12:25):
There's no right or wrong. Number one, I think the only wrong decision, is a decision that keeps you from investing in the future. So, your personal comfort matters. It absolutely matters.
So, while lump sum investing tends to outperform, that shouldn't be the reason to do it if you're going to be uncomfortable.
And then maintain a long-term focus, don't invest if it's short-term, know that it's long-term, and how those numbers typically work out in making your decision.
Jon Gay (12:58):
Great advice as always, Amy. And if you want to talk to Amy and her team at Thimbleberry Financial about the behavioral finance piece of it, the actual number is behind all of this, I know she and her team are always available. What are the best ways to find you?
Amy Walls (13:09):
They can reach us at 503-610-6510, or online at thimbleberryfinancial.com.
Jon Gay (13:18):
Great stuff as always, Amy. We’ll talk again in a couple weeks.
Amy Walls (13:20):
That sounds great, Jag. Look forward to it.
Jon Gay (13:23):
Securities offered through registered representatives of Cambridge Investment Research, Inc, a broker-dealer, a member of FINRA/SIPC, advisory services through Cambridge Investment Research Advisors, Inc, a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.
Discussions in this show should not be construed as specific recommendations or investment advice. Always consult with your investment professional before making important investment decisions.
Securities offered through registered representatives of Cambridge Investment Research, Inc, a broker-dealer, a member of FINRA/SIPC, advisory services through Cambridge Investment Research Advisors, Inc, a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.