Investing Strategies: Lump Sum Investing vs Dollar Cost Averaging
When you start thinking about the volatility we have seen in the stock market over the last couple of years it is no wonder why so many people are afraid to invest their hard earned dollars. The thought of buying shares of stock or purchasing into a mutual fund and have the market plummet can make even those of us with an iron stomach a little bit sick to our stomachs.
When people invest they usually follow one of two methods. They either invest with a lump sum approach or they purchase shares using the dollar cost average method. When you invest with a lump sum you take the entire amount you want to invest and put it to work all at once. When using a dollar cost average method you will just take a portion of the money and invest it and then invest another portion at a later date and so on.
The reason why I like investing using a dollar cost average approach is because no one can perfectly time the direction the stock market is going to go. We can purchase an investment at the markets bottom or we could invest right before a large bubble bursts as some of you might have in 2008.
A good example of dollar cost averaging is what most of us do with our 401k or IRA accounts. We have it set up to invest a specified amount over a defined period, usually bi-weekly or monthly. Because this will cause you to sometimes buy at the bottom and sometime buy at a top it will equal a lower fluctuation in your portfolio over the long term which should allow you to sleep better at night.
Where people start to get into trouble is when the market starts to go down and they get scared and stop their regular investments. We all want the market to go up but let’s be realistic, everything that goes up must come down at least some times. When this does happen it is your best chance to make money because you will have an increase in buying power.
I’m going to go through an example to show you how this all works. Let’s say Samantha receives a $1,000 bonus at work and decides she wants to invest $100 in a mutual fund over the course of ten weeks. Â Without knowing what is ahead of her Samantha starts investing right before the market starts a monthlong decline. Â Here is how the first few weeks will look like for Samantha:
- Average Purchase Price: $11.17
- Total Invested: $500
- Market Value: $459.57
- Average Price Per Share: $10.24
Now after 5 straight weeks of stock prices going down they start to see a rebound as shown below.
- Average Purchase Price: $11.33
- Total Invested: $1,000
- Total Market Value: $1,101.70
- Average Price Per Share: $12.45
Let’s take a closer look at the results from investing with the dollar cost average method. Because Samantha invested her $1,000 over the course of 10 months she ended up turning her $1,000 into $1,101.70.
Now let’s assume she had just wanted to invest it all at once. If she had done that on January 1 her $1,000 would have only been worth $1,037.75 on October 1. If she had decided to invest her entire $1,000 on May 1 her investment would have been worth $1,215.82.
So as you can see if Samantha did a lump sum investment she could have earned either $37.75 or $215.82, but by using dollar cost average she automatically made $101.70. I’m always willing to take a guaranteed profit over one where I need to be able to time the markets bottom.