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Is Dollar-Cost Averaging Better Than Lump-Sum Investing? | Comment Below - YouTube
Channel: TD Ameritrade
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Say you've got a chunk of
money you want to invest.
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Is it better to put it to work in the market
all at once or to buy gradually over time?
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I'm Cameron May and this is Comment Below.
Brandon Low commented, Great content. Hey,
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thanks Bandon. I hope you can do a video
comparing dollar-cost averaging and lump-sum
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investing. Which are better
performers in the long run?
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Well, Brandon, the debate between
dollar-cost averaging and lump-sum
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investing is a long one. Let's look at each side.
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Dollar-cost averaging is continuously investing
the same amount of money in a security over time,
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regardless of fluctuating prices, rather
than the entire amount all at once.
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For example, if you wanted to invest $1,000
in shares of a stock that's currently trading
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at $50 per share, you could break it into
five increments of $200 to purchase shares
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at regular intervals. Let's say you were able to
purchase shares at $50, $48, $47, $51, and $52
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over a period of time. Your average price per
share would be $49.60. On average, this saves you
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forty cents per share compared to the $50 initial
stock price if you had bought it all at once.
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There are couple of benefits to this. First,
you have a psychological benefit of not risking
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the entire amount immediately and having the
anxiety associated with the stock falling.
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Second, if the stock falls
after your first purchase,
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you're only losing on a small
amount, and the pain is less.
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Third, as you saw with the
example, buying over time
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could bring down your average
cost per share if the stock drops.
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However, there are risks. If the stock price
rises over time, you're buying at a higher price,
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which will increase your average price per share.
Not to mention missing out on possible gains if
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you'd invested the full amount at the beginning.
Of course, if the stock price falls over time,
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you'll keep buying at lower prices, but
there's no guarantee the stock will go back up.
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Also, investors who practice frequent dollar-cost
averaging may generate additional trading costs,
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commissions, and other transaction
costs that outweigh any cost benefit.
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Another approach is lump-sum investing,
which is the immediate investment into
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a security using all available funds.
So, going back to the earlier example,
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it'd mean investing the full
$1,000 at once for $50 per share.
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If the stock rises, you're all
in, and you get all the benefits.
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If the stock falls, you're all
in, and you get all the losses.
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Over the years, investors and scholars have
studied these strategies with mixed results.
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The winning strategy varied based on factors like
time frame, whether the results were adjusted for
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risk, and how performance was measured.
For example, check out this chart from
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a 2020 study, which compares the performance of
dollar-cost averaging versus lump-sum investing
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over time. When the line is above the zero
level, dollar-cost averaging is outperforming
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lump-sum investing. When the line is below
the zero level, lump sum is outperforming.
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So, either strategy may outperform at a given
time. Because the line spends more time under
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the zero level, lump sum is more often the
winner. However, this chart doesn't account
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for the risk associated with each strategy.
Let's look at the standard deviation of returns
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for the two strategies. Standard deviation,
defined as a measurement of the average
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absolute deviation from the mean, is a measure of
volatility or risk. The chart shows that lump-sum
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investing has greater volatility, which means
it has greater risk than dollar-cost averaging.
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So, what does this all mean? First,
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which strategy is the best will depend
on market conditions. Not surprisingly,
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lump-sum investing has historically performed
better during bull markets than bear markets.
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Second, the better strategy
depends on your risk tolerance.
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If you forecast a bull market and
you have a higher risk tolerance,
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lump-sum investing is likely the better
choice. However, if you're forecasting
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volatility and you're risk adverse, then
dollar-cost averaging may make the most sense.
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Of course, dollar-cost averaging is only
one way to manage risk in a portfolio.
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Lump-sum investors can potentially lower their
risk and increase their returns by rebalancing
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their portfolios. Rebalancing is the process of
selling some of an outperforming asset and using
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the proceeds to invest in underperforming assets
in order to maintain a preferred investment mix.
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For example, let's say you had a 50% stock and a
50% cash portfolio that you rebalanced each month.
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Studies have shown that a lump-sum
investment with a rebalancing strategy
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outperformed both dollar-cost averaging and
lump-sum investing without rebalancing by
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creating greater returns with lower risk.
Perhaps, the bigger lesson to be learned
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is that investing often comes down
to managing risk, and to do that,
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you need to consider your whole portfolio.
Dollar-cost averaging allows you to manage
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some risk on entry, but lump-sum investing plus
portfolio management strategies like rebalancing
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may provide the best of both worlds:
putting money to work more quickly
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along with risk management throughout the lifetime
of your investments. Regardless of which approach
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you choose, be aware of your risk tolerance and be
intentional about your strategy for managing risk.
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the link in this window. Tell us if you think
dollar-cost averaging or lump-sum investing
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is better for you and your risk tolerance. And
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