A question we have been asked repeatedly over the last six months has been: what is the best strategy to get into the market with new money? Invest all of it at once? Or invest in smaller increments over time through dollar-cost averaging?
The most important thing to keep in mind is that the decision of how to get into the market is secondary to investing prudently and efficiently, to begin with.
- Do you have an investment plan that reflects your personal goals and risk tolerance?
- Is your portfolio comprised of a balanced mix of low-cost, globally diversified investments?
- Are you committed to your investment strategy, regardless of market conditions?
If the answers to these questions are yes, then exactly how and when you invest new money is less significant.
That being said, lump-sum investing generally improves the likelihood of earning higher returns than dollar-cost averaging and that is because, over time, markets go up more often than they go down. Therefore, when the choice is available, a rational investor should prefer lump-sum investing to dollar-cost averaging.
However, there are considerations beyond just returns that should be taken into account. The best approach, which will vary from person to person, is the one that will enable you to adhere to your overall financial plan.
As an example, think back to last year, just before the initial implications of the COVID-19 pandemic were known. If you had invested money on February 15th, you would have had to endure a sharp and dramatic decline in the value of your investments over the next four weeks. What will you do if something like that happens again? Can you stay invested, or would you be tempted to cash out? If you think you might be tempted to liquidate your investments, you might be better off dollar-cost averaging. By reducing the risk of investing all of your funds just prior to a market crash, dollar-cost averaging may give you the confidence and peace of mind needed to stick to a long-term plan, even if on average it’s a suboptimal strategy.
So, while quantitative factors would suggest lump-sum investing is optimal, your temperament, risk tolerance, peace of mind, and overall financial situation need to be considered. Lump-sum investing is generally expected to deliver better long-term returns IF you are willing and able to stick with the strategy. But dollar-cost averaging may be the better choice if it enables you to stick to your overall investment strategy; the one that was designed to give you the best chance to achieve your financial goals, no matter what the markets have in store.