The 2 most common approaches to investing are the lump sum method and the dollar cost averaging investment method.
Both of these methods are sound, there really isn’t any right or wrong way, what’s more important is what you’re investing into. However, these methods still have some pro’s and con’s we can discuss and we can explain how each of these methods work in detail.
If we compare these two investing strategies side by side, over the long term lump sum investing slightly out performs the dollar cost averaging investment method in terms of returns. Not by much, however many times the dollar cost averaging investment method is more practical as many investors or would-be investors don’t have access to large cash reserves to invest a lump sum of money.
If you are an investor that’s just starting out and you want to factor an investment each month into your financial budget then dollar cost averaging investment is for you. Also if you’re an investor that wants to cut down on your investment risk, then you might want to consider dollar cost averaging.
Dollar Cost Averaging Investment
Is when you invest a consistent amount of money to the same investment, over a period of time. For instance, you might want to invest $500 a month into an index fund ETF like Vanguard S&P 500 Index Fund ETF. So you do so each month, for the foreseeable future.
So, basically you are investing when the markets are high, or when the markets are low. It allows you to be more commercial in your decisions and removes some of the emotion out of a lump sum investment price fluctuation.
Dollar Cost Averaging Investment example:
If you invested $500 into a company that stocks trade at $20, one month you will buy 25 shares, if later it goes to $50 a share you will purchase 10 shares and if it drops to $10 a share you will buy 50 shares.
If you’re investing into index tracking ETFs, the only time you will usually lose money is if you withdraw or sell your position. When markets fall, this is when people sell due to fear, however if you stick to a dollar-cost-averaging strategy you can take advantage of the fall in price by accumulating more shares in the ETF at a lower price. Knowing full well that over time the markets will bounce back and you will have made a good investment long term.
There is one pro with lump sum investing in that markets go up over time. This means that the earlier you invest the lump sum, the greater chance you have of better returns than sticking to a dollar-cost-averaging strategy. This is because you have your money in the market rather than not.
However, some of the reasons dollar cost averaging investment is a better strategy for the average investor is:
Removes bad market timing
When you implement a dollar cost averaging investment strategy, you are not trying to time the market. We know from history that it’s practically impossible to time the market, many people have lost fortunes and gone bankrupt from trying to time the next bull run.
When you stop trying to time the market, you start to focus on the asset and it’s long term performance.
Then you focus on the $ amount you can contribute to this asset over time. This allows you to invest with your head, not rely on your gut on when to buy or sell at specific times, also people who adopt dollar-cost-averaging invest in more stable and consistent assets, rather than the “get rich quick” mentality of short term stock trading.
Reduces the emotional component
A dollar cost averaging investment strategy is more mechanical, if it focuses on your personal finance situation and what you can invest each month. From there you’re making commercial decisions on what to invest in for the long term. If you don’t enough money left each month to invest, then perhaps start with our how to manage your money section.
You go into the strategy knowing that there will be ups and downs and that a down market, just creates more opportunities for you. Due to this you will continue on your pre-set course, regardless of price fluctuations, which means you will stick to your strategy.
The less experienced you are as an investor the more a dollar cost averaging investment strategy makes sense. However, remember even experienced investors can’t outperform the market 75%+ of the time. When you invest in good quality index fund ETFs with low expense ratios you are going to outperform the majority of investors.