Sunday 15 November 2020

Should I start dollar cost averaging or a lump sum investment?

Dollar cost averaging or to a lump sum investment? This is a question on everyone's mind when they start to invest. And this is also today's topic for this video. There are many debates on whether dollar cost averaging or lump sum investment is better.

Before, I dive in more into DCA and lump sum investing, please give an early thumbs up or subscribe to my channel for me to produce more content for you guys!

So let's define them. Dollar cost averaging (DCA) is an investment strategy in which an investor divides up the total amount to be invested across periodic purchases of a target asset in an effort to reduce the impact of volatility on the overall purchase. For example, you have $25,000 you split it up and invest about $500 per month. This will mean that the $25,000 will be invested over a 4 year time period.

On the other hand, a lump sum investment would mean that the $25,000 would be invested straight into the stock market. There are definitely pros and cons to both strategies. I am going to talk about each method.

Dollar Cost Averaging

There are some advantages to DCA. Dollar-cost averaging helps spreads the risk of investing as you are spreading out your investments over a period of time meaning that you are buying both the lows and highs. This also means that you can take advantage of a market downturn as you will have funds on hand. The emotional factor is also taken out of it.

DCA is a good way to start if you do not have a huge sum of money available as putting money in consistently is beneficial in the long-term. It is also good if you have a large sum but are more of a nervous investor with lower risk tolerance.

A disadvantage of dollar-cost averaging is that the market tends to go up over time. This means that if you invest a lump sum earlier, it is likely to do better than smaller amounts invested over a period of time. The lump sum will provide a better return over the long run as a result of the market’s rising tendency.

Lump Sum Investing

There are definitely pros and cons to LSI as well.

Historically, lump-sum investing has a higher chance of outperforming dollar-cost averaging

Lump-sum investing gives your investments exposure to the markets sooner provided the markets are going up as you are putting your money to work right away which takes full advantage of market growth.

One disadvantage is that you might have no extra money to take advantage of a market downturn as most of your money would have been invested

Studies on dollar cost averaging VS lump sum investing

A study from Vanguard which I will put the link below have shown that lump sum investing produces better results. The study uses monthly stock and bond returns in the United States, United Kingdom, and Australia to evaluate the historical performance of each strategy. For LSI, we assume that US$1,000,000 (or £1,000,000 in the United Kingdom and A$1,000,000 in Australia) is immediately invested into a stock/bond portfolio and then held for 10 years. For DCA, we assume that the same sum starts in a portfolio of cash investments and is then transferred in equal increments into a stock/bond portfolio over a period of 6, 12, 18, 24, 30, or 36 months (with 12 months being our baseline scenario in most examples and exhibits). Once the DCA investment period is complete, the DCA and LSI portfolios have identical asset allocations, and both remain invested through the end of year 10.

Conclusion of the study:

If the markets are trending upward, it is logical to implement a strategic asset allocation as soon as possible because it should offer a higher long-run expected return than cash. Historically, a long-term upward trend has persisted for both equities and bonds, probably attributable to positive risk premia in the markets. In other words, positive returns have compensated investors for taking risks, hence the upward trend in those markets and the resulting probabilities of success for LSI. So, to the extent that an investor believes the positive risk premia are likely to exist in the future, LSI would remain the preferred method for investing an immediately available large sum of money. But if the investor is primarily concerned with reducing short-term downside risk and the potential for regret, then DCA may be a better alternative.

Which is the better investing strategy?

Research has definitely shown that lump sum investment is better as your money is in the stock market straight away because time in the market is beneficial. But if markets are going down and you are wondering if it is the right time to invest as you are afraid that the markets will continue to fall, this is when DCA is for you to take advantage of the drop. Also, emotions can run high if you invest a lump sum at one go. DCA on the the other hand will allow you to minimize the downside risk.

All in all, there will be individuals who prefer LSI or DCA, you will need to know your emotions and whether are you able to sleep if you take on more risk.


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