When it comes to investing, you may prefer taking evenly spaced small steps, steadily building your wealth in intervals. Alternatively, you may prefer investing every now and then with a larger sum.
If you’re after a disciplined investment strategy that lets you advance incrementally, dollar-cost averaging (DCA) may be for you. Those wanting a deep dive in can take the lump-sum route. Let’s look at each strategy more closely.
Dollar-Cost Average Investing
DCA works by accumulating an investment product bit by bit, over intervals such as monthly or quarterly.
You can set up recurring payment plans to spend a fixed amount on assets like stocks and cryptocurrencies. Automated DCA investment payment arrangements can be made through selected banks, brokers or crypto exchanges.
Whether it’s shares or cryptocurrency, the quantity of the investment product you buy when dollar-cost averaging will likely differ across intervals. That’s because market prices are always changing.
Your fixed dollar amount will buy you more when prices have been falling and less when rising. Over the duration of your investment, you’ll have achieved a “cost average”, which is simply the average price paid for your accumulated investment.
Let’s imagine you want to use DCA to buy company shares over 12 months.
- You arrange to automatically invest $1,000 per month.
- Your January investment of $1,000 bought you 100 units at $10 each.
- For February, March and April, the unit price was $8, so you bought 125 units per $1,000 spent per month—or 375 units over 3 months.
- In May and June, the unit price was $12.50, so you bought 80 units per month’s $1000 investment—or 160 units over 2 months.
- For each of the remaining 6 months, the unit price was constant at $9.50, so you bought 105 units per $1,000—or 630 units over 6 months.
- After 12 months, you’ve spent $12,000 and your total holdings are 1,265 units.
- Through that time the cheapest buy price was $8 and most expensive was $12.50.
- The average cost came to $9.49. That is, $12,000 divided by 1,265.
Lump Sum Investing
A lump sum is a single complete sum of money. Investing a lump sum means you want to use your money to buy an investment product in full at the outset, rather than a regular periodic investment.
For example, you might want to invest $12,000 through lump sum investing.
- All $12,000 is invested through a single transaction.
- At the time the price per unit was $10 per unit.
- Your money bought you 1,200 units. That is, $12,000 multiplied by 1,200.
This type of investing requires you to accept that you’re committing to the investment at its current price and you’re comfortable with the timing of your investment. You may accept the difficulty of ‘timing the market’—that is, appreciating that the market fluctuates and at different times you may have been able to buy cheaper.
You may choose to buy more later, making another lump sum purchase to increase your holdings. Doing so on an irregular basis isn’t the same as a DCA strategy.
Summing It Up
Each of these investment approaches has its benefits. Knowing your personality type can help you decide why you might choose one approach over the other.
A lump sum investing strategy can help significantly increase your holdings from the outset. There can be a faster rate of growth of the investment, as earnings can be re-invested to generate further earnings. Compounding benefits are maximised.
If you’re inclined to panic or make rash decisions—perhaps due to high market volatility—a DCA strategy may work well. You can remain an invested market participant and ride out the turbulence.
Your regular periodic investment amounts would buy greater volumes of stocks, cryptocurrencies or other assets during market downturns. This would magnify your upside should a strong market recovery follow.
Similarly, you may tend to procrastinate, waiting until the price drops to a particularly low level before investing. This could result in you staying uninvested for a long time and not putting your money to work.
If this form of uncertainty is stopping you from investing, then dollar-cost averaging can get you moving. You don’t need to judge whether now is the ‘perfect time’ to buy and you can accumulate an investment over an extended period.
DCA helps reduce the risk of ‘mis-timing’ your entry into an investment. (Buying all at or near the peak price can happen when lump sum investing.) With DCA, you’ll have a spread of prices, with lower-priced purchases countering those which were highly priced. The average cost is brought down, minimising the risk of paying ‘top dollar’ for the entire investment.
Of note, neither a DCA nor a lump sum investing strategy protects against market downturns. Either way, you may need to occasionally consider exiting or switching investments.