Dollar cost averaging or lump sum, which is the best approach for an investor. The unequivocal answer is either one depending on your situation.
Basic Investment Strategies
Below is a brief explanation of the two investment strategies. Have also thrown in another strategy that is similar to dollar cost averaging.
Dollar Cost Averaging (DCA) is defined as the investment strategy of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high. An example of this type of investing is to purchase $1,000 of shares each month to in a mutual fund for a total of $12,000 over a year.
Lump Sum Investing (LSI) is defined as the investment strategy of buying a particular investment at one time. An example of this type of investing is entering in an order to purchase $12,000 worth of shares at a single time. Typically additional purchases would not be made in a significant amount.
Value Averaging (VA) is defined as an investing strategy that works much like dollar cost averaging (DCA) in terms of steady monthly contributions, but differs in its approach to the amount of each monthly contribution. In value averaging, the investor sets a target growth rate or amount on his or her asset base or portfolio each month, and then adjusts the next month's contribution according to the relative gain or shortfall made on the original asset base. An example of this type of investing is to start by purchasing a set number of shares, and over a period of a time purchasing additional shares each month so that the account value equals $12,000. The number of shares would vary depending on the price of the shares. Months when the price is lower than the intital purchase price, more shares would be bought and the opposite when prices are higher.
Which Strategy Yields The Best Returns?
Using historical data to compare the DCA strategy to the LSI strategy, the LSI method returns higher results 2 out of 3 times. Here is a tool that allows you to test the two methods for each month of the year since 1950. LSI has the advantage since the overall trend of the stock market has been to increase in value year to year. In a rising stock market, DCA is hurt by the fact that with each purchase the cost basis of the shares increases while the LSI cost basis remains constant. Typically in a market that is in a down trend, the DCA strategy comes out ahead because with each purchase the cost basis is lowered.
Below is a chart from AllFinancialMatters.com, that compares DCA strategy to LSI strategy. The LSI strategy (account value) took $19,900 and invested in the Vanguard S&P 500 Index fund on January 2, 1990. The DCA strategy invested $100 at the begining of each month from January 2, 1990 to July 3, 2006, which works out to a total of $19,900 (199 months multipled by $100 each month).
Practical Advice
If you come into a large amount of money and want to invest it, you are better off putting it on all at one time. First is the evidence clearly shows that in most cases you will come out ahead by lump-sum investing. Secondly if you invest it all at one time, you will not be tempted to spend it.
Most of us cannot afford to take a large sum of money at one time and invest it, by default we have to dollar-cost average. An employee sponsered retirement plan (401K or 403B) is a perfect example of dollar-cost averaging. If this is the only way that you can afford to invest, this is your best option.
Source:
'Dollar Cost Averaging', Investopedia.com
'Value Averaging', Investopedia.com
'Dollar Cost Averaging v. Lump Sum Investing - Part II', by JLP, allfinancialmatters.com
'Lump Sum Beats Dollar-Cost Averaging' by Richard E. Williams, Ph.D., and Peter W. Bacon, DBA, CFP, Journal of Financial Planning
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