Lump sum versus dollar cost averaging
- Alan Lavine and Gail Liberman
Research in recent years has shown that investing a lump sum often is better than dollar cost averaging, or investing a specific amount periodically. But dollar cost averaging is clearly superior when it comes to reducing the risk of an investment underperforming for a long period, contends a recent article in the Journal of Financial Planning.
If you invest a lump sum, you may be able to earn more. But Robert Dubil, an associate professor of finance at the University of Utah, notes in that whether a lump sum outperforms a dollar-cost averaging strategy "depends crucially on the sequence of stock returns."
Dubil's study indicates the following:
- If stocks trend upward, the lump-sum approach dominates.
- Dollar cost averaging may work better if stocks are trending downward. This tactic also works well with volatile stocks or common stock mutual funds whose prices fluctuate a lot. The reason: Dollar cost averaging buys less stock when prices are higher and more stock when prices are lower. Long term, the average cost of your investment should be lower than the market price when you expect to sell.
- The results of his study show that a dollar cost averaged investment can be 40 percent less volatile than a lump sum investment over the longer term. Dubil's analysis is complex. Say a stock price dropped 10 percent in value, but a while shot up 25 percent: The dollar cost averaged investment would drop about 4 percent. Then it may shoot up about 10 percent.
- Investors who use dollar cost averaging can reach their investment goals on time. By contrast, a lump sum investment could decline due to a stock market crash just when you need the money.
"While dollar cost investors give up return by delaying their investment," Dubil says, "this study shows that the risk reduction benefits of dollar cost averaging are real."
Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books). Al and Gail's new book is Rags to Retirement, (Alpha Books).
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