Imagine that you have a sum of money, say $12k, perhaps from a bonus, inheritance, or some excess savings, that you want to invest.
But you’re not sure what strategy you should use to invest this money.
Well, you’ve come to the right place.
As the name suggests, this post is a beginner’s guide to the 2 most popular ways to invest your money – lump-sum investing (LSI) and dollar-cost-averaging (DCA).
I’ll go over what they are, how they work, their pros and cons, and who they’re suitable for.
Note: This post assumes that you’re planning to be a long-term passive investor, mainly investing in index ETFs.
Lump-Sum Investing
What Is It?
LSI is when you choose to invest all of your money intended for investments in one go.
If you have $12k set aside for investing, that would mean investing all $12k at once.
How Does It Work?
The rationale behind the strategy of LSI is simple – to maximise the amount of money that is invested ASAP in order to maximise investment returns.
Since markets tend to trend upwards, by having your money invested sooner, you stand to capture more returns in the long run as compared to having your money invested later.
Pros
Higher Returns
A Morningstar study concluded that LSI outperforms DCA in terms of long-term returns 90% of the time in a 10-year time frame.
JP Morgan found that LSI outperforms DCA 70% of the time in a 5-year time frame.
That’s a huge margin, and when you think about it, it means that LSI is successful at achieving what it’s intended for – maximising returns by having more money invested ASAP.
The fact of the matter is that markets go up in the long run, so more money invested longer = higher returns.
Set & Forget
With LSI, there’s no need to worry about how prices fluctuate next week, next month, or even next year.
You’re in it for the long run, so prices would only matter to you 10 years down the road, if not longer, when your investments may start to cover some of your daily expenses.
This allows you to adopt a “set & forget” mentality towards your investments and not let it get in the way of your life.
On the other hand, someone who’s chosen to DCA would likely be more sensitive to short-term price movements.
Since they’ve intentionally held off from investing some of their cash, they’d hope that prices drop in the coming months to get the most out of their DCA approach.
Thus, they may find themselves thinking or worrying about their investments every so often.
Lower Fees
Since you’re only investing once with LSI as compared to multiple times with DCA, chances are that you’ll incur lesser fees.
This is because even though your total amount invested with LSI and DCA is the same, many brokers charge a minimum fee for each transaction.
So you’ll end up incurring this minimum fee multiple times with DCA, but only once with LSI.
However, if you happen to use a broker with no minimum fees or use a Robo-advisor instead, then the fees you incur will be the same.
Cons
Higher Short-term Risk
Personally, I don’t think this risk lies in the investment or the market, but rather the individual investor.
With LSI, where all your capital is invested into the market at once, there’s always a chance that the market crashes the following day or week.
As a result, you may experience significant paper losses.
In the long run, this doesn’t really have an impact on your returns as long as you don’t sell, because the market will recover and prices will likely climb higher than what you had originally bought in at.
But if you’re just starting to invest or have a small risk appetite, when you see that your portfolio’s value has dropped, paper losses may come across as realised losses and lead you to sell off your investments.
This is the risk – being overcome by the psychological impact of paper losses and realising these losses.
Who Is It For?
Given the aforementioned risk, LSI is a strategy that should only be adopted if you’re confident that you won’t panic sell during a market dip/correction.
This usually means that you need to have a large risk appetite and a strong fundamental understanding of how long-term investing works so that you can remain grounded even when the market is in turmoil.
Dollar-Cost-Averaging
What Is It?
DCA is when you divide your money into fixed amounts and invest them over a period of time.
So if you have $12k set aside for investing, that could mean investing $1k/month for 1 year.
How Does It Work?
DCA aims to spread out the amount of money that is invested over a period of time as a means to combat the price volatility of an investment.
Since stock and stock ETF prices tend to fluctuate, by investing your money in batches, you are able to average out the buy-in price of your investment to lower the risk of buying in at unusually high prices.
So there will be times where you buy high, and other times where you buy low.
Pros
Smoothen The Ride
By averaging out the buy-in price of your investments, DCA can help to make your investment journey a little bit less bumpy.
Since you’re trickling your money into the market rather than dumping it in all at once, if the market crashes shortly after you’ve made an investment, it’ll have a smaller impact on you because not all of your capital is affected.
Instead, you may be able to make some investments at a discount, which would not be possible if you’ve invested all your money previously, as with LSI.
Warming Up
For most people, getting started with investing is a scary thing.
Even if you know what to expect and how you should react, you’ll never really know how market volatility and its impact on your investments will mentally affect you until you’ve experienced it.
And if you don’t know how you’re going to be affected, you definitely won’t know how you’re going to react, and that can be scary because you have money at stake.
DCA allows you to dip your money into the market and gain experience.
Over time, after learning what your investment psychology is like, you can possibly develop a strategy that works for you.
For example, if you find out that market volatility is something that bothers you, you may utilise various asset classes to create a portfolio that helps to minimise volatility.
If you had dived into the market with LSI and experienced severe volatility, you’d be vulnerable to making the mistake of selling your investments during a decline and incur heavy losses.
Cons
Lower Returns
As mentioned above, LSI has historically been shown to outperform DCA most of the time.
Higher Fees
Also mentioned above, DCA will incur more transaction costs as compared to LSI due to the higher number of trades being made for the same amount of capital if the broker charges a minimum fee.
If there is no minimum fee, the fees incurred would be the same.
Requires Discipline
Unless you’re on an RSP that automatically transfers money out from your bank account every month, you’ll need to have the discipline to invest on your own every month for DCA.
This can be especially hard for beginners not because they forget, but because if they see prices increasing every month, they may feel inclined to wait a little longer and hope that the price drops.
And if it never does, well, it’s easy to just not invest until the following month, and this can have a detrimental impact on investment returns.
Who Is It For?
DCA is the more beginner-friendly approach for people who are new to investing.
If the thought of investing or losing money scares you, DCA is a good way to get started, gain experience, and overcome that fear.
Or if you’re unsure of your risk appetite and how you’ll react to market movements, DCA will allow you to learn as you invest, so you don’t leave all your cash idling in the bank.
To summarise,
Both LSI and DCA are good for different purposes.
While LSI offers the potential for higher returns and lower fees, it may be risky for beginners with little or no investing experience.
On the other hand, DCA is a good strategy for beginners to dip their toes into the market and learn more about their investing psychology through experience.
At the end of the day, as long as you start investing, you will be on track to a better financial future.
Did you start investing with LSI or by DCA? Let me know in the comments below!