When you invest in assets like stocks and mutual funds, it’s important to understand the differences between investment techniques. Two major investment techniques are lump-sum investing and dollar-cost averaging. With lump-sum investing, you choose how much money to contribute to your investment in one shot. With dollar-cost averaging, you contribute fixed amounts of money on a regular basis (e.g., every week or month). While both methods have the potential to help you achieve the same long-term financial goals, they each have their own set of advantages and disadvantages. Let’s explore!
Lump-sum investing vs. dollar-cost averaging: what’s the difference?
Lump-sum investing is when you invest a sum of money all at once. For example, you may have a spare $10,000 to invest, and you decide to allocate everything to Tesla’s stock. Generally speaking, this strategy is riskier simply because all your money is exposed to market risk at once. The old adage “high risk, high reward” stands true here; multiple studies, including one from Vanguard, have demonstrated this.
Dollar-cost averaging is an investing technique whereby an investor purchases a fixed dollar amount of a particular security at regular intervals. Let’s say you have that $10,000 to invest, but don’t want to spend it all at once. You can decide to split it up over the next 10 months and invest $1,000 every month. The goal here is to limit the impact that sporadic, downward market changes have on your investment.
The pros and cons of lump-sum investing
You might be wondering what the benefits and drawbacks of lump-sum investing are. Let’s take a look at the main ones.
- Potentially higher profit due to the long-term relationship between risk and return.
- Only one investment decision is required.
- More negotiating power with a broker when placing a large order of securities.
- More exposure to market risk.
- Profiting from a lump-sum investment implies that you correctly “timed the market” and adhered to the “buy low, sell high” principle. However, if you purchase assets when prices are high, you could potentially lose out if you’re forced to sell them at a time when prices have dropped.
- You need an investable lump-sum to begin with, which many aren’t fortunate enough to have.
The pros and cons of dollar-cost averaging
In the same sense, you need to also consider the advantages and disadvantages of dollar-cost averaging.
- It may lower overall market risk since you’re spreading your investments over time.
- Over time, you can lower your price per share. This is because you buy more shares with a fixed amount of money when prices are lower, and fewer shares with that fixed amount when prices are higher.
- More accessible to the average person vis-a-vis investing a larger lump-sum.
- Potentially less profitable.
- Likely to pay more brokerage fees because you’re making multiple purchases rather than just one.
- You still need to pick good investments. Poor investment choices will cost you, regardless of whether you spread that investment or make it in one go.
What’s right for you?
When it comes to investing your hard-earned money, there are two main approaches you can take: lump-sum investing or dollar-cost averaging. Both have their pros and cons, so it’s important to understand the difference between the two before making a decision. Based on the pros and cons discussed above, the former may suit you better if you have a higher risk tolerance, are seeking to maximize returns, and have some prior experience in picking investments. Dollar-cost averaging may be preferable if you want to limit your market risk exposure, lower your price per share, and have less investing experience. Ultimately, you have to closely examine your current circumstances and your investment goals; this will determine which technique is right for you.