By: Sean Gallagher, CFP®
Investing can be a daunting task, especially when you have a significant amount of cash to invest. One of the most crucial decisions is when to invest. Should you commit all at once or spread out your investments over time? This article will discuss the two primary investment strategies: lump-sum investing and dollar-cost averaging.
First, it's essential to understand that market timing is not a reliable driver of long-term wealth accumulation. Trying to find the perfect time to invest can often leave an investor worse off than if they had blindly invested right away. Therefore, the two main options for implementing cash into an investment strategy are lump-sum investing and dollar-cost averaging.
What is Lump-sum Investing?
Lump-sum investing involves investing all your cash at once, right away. This strategy offers more risk but a slightly higher expected reward. However, the primary consideration is whether you're comfortable putting all your money at risk in the investment market. There's a chance the market may plummet, putting you worse off than dollar-cost averaging. But historically, the market is up more often than it is down, meaning the data is in your favor of having a higher return using this strategy compared to dollar-cost averaging.
What is Dollar-cost Averaging?
Dollar-cost averaging involves splitting your total investment over time and investing in increments throughout. For example, you break up $120,000 to be invested monthly over the next year, meaning you'd invest $10,000 each month. This strategy is more stable and conservative, limiting the impact of short-term volatility. It's typically more appealing for investors who are more emotional and worried about volatility.
As an avid golfer, I compare this decision to a common dilemma on the golf course. You've just hit a beautiful drive off the tee, landing in the middle of the fairway, and are at a distance that puts you on the borderline of reaching the green in one swing. Do you go for it and use the more unpredictable three wood to try and reach the green? Do you lay up and use a shorter, more accurate club to land before the green and then chip on?
Attempting to reach the green can be rewarding - you can be in the hole in just two shots (after one putt) if everything goes right. It can also go wrong if the more uncertain long-range club causes you to miss the green and find a tree, bunker, or water. Suddenly it takes three, four, or even five shots to get in the hole.
On the other hand, using the more accurate seven-iron and then wedge to play a shot in front of the green and then chip on is a slightly safer play. Depending on your putting, you're looking to be in the hole in three to four shots.
You can draw similarities between trying to reach the green as lump-sum investing and laying up as dollar-cost averaging. They both involve the assumption or perception of risk. Either you feel comfortable taking risks with things, or you feel better not assuming additional risk.
Traditionally, the major downside to dollar-cost averaging was that you were not getting any return on the cash held until it was all invested. With the rise in interest rates over 2022 and 2023, short-term government treasury bills and bank CDs can now yield anywhere from 4 - 5.50%. These yields make this strategy much more appealing to investors who can invest part of their money while still generating a return on the cash.
It's important to remember that investing is a long-term strategy and tends to work in your favor over long periods. Every investor should prepare for short-term volatility, and proper cash planning for short-term goals should help mitigate concerns about any volatility in the stock market.
Risk Tolerance
Your decision on which strategy to pursue depends on your risk tolerance. The chart below from Schwab Center for Financial Research illustrates the growth of $2,000 invested annually in the S&P 500 index from 2001-2020. The Perfect Timing and Bad Timing scenarios involve investing at the low or high for each year, which can be considered your range of outcomes. The Invest Immediately scenario involves investing everything on the first trading day of each year. In contrast, the Dollar Cost Averaging scenario invests $166.67 on the first of each month throughout the year, totaling $2,000 for that year.
Source: Schwab Center for Financial Research. Invested $2,000 annually in a hypothetical portfolio that tracks the S&P 500® Index from 2001-2020.
To sum up, investing is a long-term strategy that tends to work in your favor over long periods. Both lump-sum investing and dollar-cost averaging can be effective investment strategies. Ultimately, deciding which method to pursue depends on your situation, risk tolerance, and investment goals.
The foregoing content reflects the opinions of Highland Financial Advisors, LLC, and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions, or forecasts provided herein will prove to be correct.
Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns.
Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful or that markets will act as they have in the past.
Sean Gallagher is a CERTIFIED FINANCIAL PLANNER™ at HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Sean graduated from Virginia Tech’s financial planning program in 2018 and successfully passed the CFP® national exam in 2019. As a Financial Planner at HIGHLAND Financial Advisors, Sean works on developing comprehensive financial plans and investment management for all clients.