If you want to dip your toe into investing, it can be overwhelming. The terminology, risks and fees might make you want to just dump your funds in a savings account instead. But that would be a mistake – investing can be a great way to grow your assets over time and with the right strategy you can mitigate risks and maximize returns.
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What Is Dollar-Cost Averaging?
According to FINRA, dollar-cost averaging is an investing strategy where you break up your funds into portions and invest one portion at a time. For example, if you have $5,000 you’d like to invest, instead of investing all $5,000 at once, you could invest $1,000 at a time on a set schedule.
Using this strategy, you might put $1,000 in investments each month for five months. As the market rises and falls over that period, some months $1,000 might buy more shares and some months it might buy less.
Dollar-cost averaging allows you to invest steadily while lowering your overall risk. It can also help you establish the habit of investing without falling prey to the impulse to game the market—that is, try to predict the exact right moment to invest.
What Is Lump Sum Investing?
Lump sum investing is essentially the opposite of dollar-cost averaging. In the above scenario, you have $5,000 and invest it slowly, month by month. If you instead use the lump sum method, you would immediately invest all $5,000—no breaking it up and investing it over time.
While dollar-cost averaging might make risk lower and more palatable, lump sum investing can provide larger returns. It gives your investments more exposure—meaning you have more to gain if the markets rise. Of course, that also means you have more to lose if markets fall.
What Are the Pros and Cons of Each?
As you may have already noticed, there are upsides and downsides to both strategies. Here are some of the more important considerations.
Dollar-Cost Averaging
- By taking a slow and steady approach, you may be able to invest less emotionally. Since you’re establishing an investment habit regardless of the economic climate, you may be able to sidestep some of the common emotional mistakes investors often make.
- This strategy does help mitigate risk. Since you’re investing over time, the specifics of the market on any particular day aren’t as impactful as they might be when lump sum investing.
- On the negative side, while dollar-cost averaging can mitigate risk and allow you to pay lower average share prices over time, you could also see lower returns than you would with lump sum investing. Say you decide to invest $1,000 a month from January to May—in February the market goes up. If you had invested all $5,000 in January, you would have seen higher returns. Now, your $1,000 won’t go as far.
- Depending on how you’re investing, the dollar-cost approach might cause you to rack up more brokerage fees that can eat into your returns.
- Finally, if you invest $1,000 and leave the remaining $4,000 in your account to invest later, you might be tempted to spend that $4,000 on something else rather than invest it. If you take the dollar-cost averaging approach, make sure you’re committed and don’t touch the money you intend to invest.
Lump Sum Investing
- When you put all your money in at once, you’re more likely to see results quickly. This can be a helpful motivator for a beginning investor.
- You will often see higher returns with lump sum investing compared to dollar-cost averaging.
- Ever heard of the relationship between risk and reward when it comes to investments? On the downside, the likelihood of higher reward also comes with higher risk.
- You’ll need to manage the emotional aspect of investing as you watch the market rise and fall. Remember that impulse to game the market? You might begin to think that you can pull your money out or put it in at exactly the right time, but that’s highly unlikely. You’ll need to develop nerves of steel and let your portfolio ebb and flow with the economy.
- Lump-sum investing doesn’t build a good financial habits in the same way that lump-sum investing does. Even if you decided this strategy is right for you, make sure you’re continuing to invest going forward.
Which One Is Right For You?
Dollar-cost averaging can be a great strategy for a beginning investor who wants to get in the habit of steadily growing their portfolio. It’s lower risk and can help take some of the emotional swings out of investing. On the negative side, dollar-cost averaging can generate lower returns and generate higher brokerage fees that diminish your bottom line.
Lump sum investing is a good choice for those who can manage the emotional impulse to game the market and are confident they can build good investing habits going forward. This strategy will likely generate higher returns, though it also comes with higher risks.
The Bottom Line
Comparing dollar-cost averaging to lump sum investing can be a fruitful exercise to help you find the right strategy for you. Both investment methods have positives and negatives. You can use the information above to help you determine which one is right for you and how each method will fit into your overall investment strategy going forward.
Tips for Investing
- Learning to invest can be challenging but a financial advisor can help simplify the process for you. Finding a financial advisor doesn’t have to be hard. SmartAsset’s matching tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- A diverse investment portfolio can help you mitigate the inherent risks of the market. Use SmartAsset’s asset allocation calculator to find the right mix of investments for you.
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