WHEN I WAS LEARNING about investing, dollar-cost averaging was one of the first strategies I read about. Over the years, I’ve come across a number of articles debating the strategy’s virtues, usually comparing it to a onetime lump-sum investment.
Dollar-cost averaging consists of making a series of periodic investments rather than buying all at once. These purchases occur at regular intervals, regardless of the investment’s price that day. Using this strategy, you can purchase more shares when prices are lower. This may lead to a lower overall cost basis for the total amount invested than would result from a single purchase.
The single purchase approach is variously called lump-sum investing, plunging and—I recently came across the term—”plunking.” Instead of dividing up the amount to be invested, you invest the entire sum in one go. This gets all your cash in the market right away, giving it more time to grow.
Vanguard Group published a detailed study in 2012 comparing the results of dollar-cost averaging to lump-sum investing. In general, the returns from lump-sum investing were higher than dollar-cost averaging about two-thirds of the time. The paper measured stock and bond returns over rolling 10-year periods in the U.S., U.K. and Australia.
The paper assumed you start with a significant sum to invest. This may be the case for a few folks, as well as some endowments. In my experience, however, this is not the primary way most people save for retirement. Instead, they invest a small sum whenever they get their paycheck. They invest over time because that’s how they get paid.
I believe the best way to save for retirement is to contribute regularly and to automate the process. Today’s technology makes this easy. You might assign a portion of each paycheck to go into your retirement savings, your taxable account and your emergency fund.
The jobs my wife and I held were predominantly salaried positions with biweekly paychecks. There were occasional bonuses and cash awards, but they were infrequent and we didn’t plan on them. The market crash that began in 2007 coincided with our last year of college tuition payments, and thereafter we saved as much as we could for retirement. Regular, automated savings were our path to financial success, and the fact that we got to buy at rock-bottom prices in 2007-09 was a huge help.
What if you’re lucky enough to receive a windfall? You’ll want to consider how best to invest the money. If markets are trending up, investing it as a lump sum gives your money more time in the market to grow. If the market is trending down, dollar-cost averaging allows you to buy more shares at ever-lower prices. In other words, if you can divine the future, choosing between these two strategies should be easy.
What if you don’t have a crystal ball? Think about how important the lump sum is to your financial future. If it would be devastating to invest the money in one fell swoop and then immediately get hit with a market crash, you might opt to dollar-cost average instead.