Deciding whether to invest a large sum of money all at once or spread it out over time gives investors two strategies to consider: lump-sum investing and dollar-cost averaging.
Both have their advantages and disadvantages, and the debate over which is better is more than just a financial exercise. It’s also psychological. While historical data favors lump-sum investing, the final choice depends on your risk tolerance, emotional disposition and financial goals.
This article will help you understand the pros and cons of each strategy so you can make a decision you’re comfortable with.
Quick Verdict: Who Each Strategy Suits
- Lump-sum Investing is better for confident, long-term investors with a high risk tolerance who are comfortable with potential short-term volatility and believe in the historical upward trend of the market.
- Dollar-cost averaging may be better for risk-averse or emotionally driven investors who are anxious about market timing and want a structured, disciplined way to invest, or they don’t have a large sum of up-front cash.
Lump-Sum Investing vs. Dollar-Cost Averaging
| Metric | Lum-Sum Investing | Dollar-Cost Averaging |
| Historical performance | Outperforms dollar-cost averaging most of the time. | Underperforms lump-sum investing in most market conditions but performs better in declining or volatile markets |
| Compound annual growth rate | Generally higher because of more time in the market | Generally lower as part of the capital remains uninvested |
| Tax impact | A single capital gain or loss event. If the investment is in a taxable account, taxes are only due when the asset is sold | Multiple tax events if individual purchases are sold at different times. Not an issue if it’s in a retirement account |
Lump-Sum Investing
The core mechanic of lump-sum investing is straightforward: Invest your money in the market as soon as possible. The philosophy is that your money’s time in the market beats trying to time it.
Advocates argue that because the stock market has historically trended upward, delaying investments means you miss out on potential growth. By deploying all available capital at once, you give it the maximum amount of time to compound.
This strategy is for investors who have significant sums of cash and aren’t concerned about short-term market fluctuations. They’re focused on the long-term goal of maximizing returns and are comfortable with the risk of a potential dips in value.
An ideal lump-sum investor may be a young professional with a recent bonus or inheritance, or someone who’s sold a property and wants to reinvest the proceeds for multiple decades.
- Pros: You’re more likely to see higher returns and faster results by putting all your money in at once, which can be a motivating factor.
- Cons: Although the payoff may be greater than with dollar-cost averaging, the risk is also higher. You also must manage the emotional temptation to time the market.
Dollar-Cost Averaging
Dollar-cost averaging involves systematic investments of a fixed amount of money over regularly scheduled intervals. This approach recognizes that human emotions like fear and greed can lead to poor investment decisions. By automating the process, dollar-cost averaging removes emotion from the equation.
Investing a fixed amount, such as $1,000 every month for a year, means you’ll buy fewer shares when prices are high and more shares when prices are low, which can result in a lower average cost per share over the investment period.
Dollar-cost averaging is a great fit for investors who get nervous seeing their portfolios drop. It’s also a good approach for anyone who receives regular income, such as through a paycheck. Saving for retirement through a 401(k) or contributing monthly to a Roth IRA is, by default, dollar-cost averaging.
This strategy provides a sense of control and reduces the mental stress of asking yourself whether you invested at the top of the market.
- Pros: Because you’re investing over time, dollar-cost averaging helps mitigate risks. You’re also establishing an investment habit independent of the economic climate.
- Cons: You might see lower returns than you would with the lump-sum approach. If your brokerage charges transaction fees, they could eat into your returns over time.
Implementation Guide: ETFs, Apps, Brokers
Regardless of whether you choose lump-sum investing or dollar-cost averaging, the key is to be consistent.
For either strategy, a simple and easy way to invest is through diversified, low-cost exchange-traded funds that track broad market indexes like the S&P 500 or a total stock market fund. ETFs provide instant diversification, making them suitable for all investors.
Most investment platforms are built to accommodate both strategies. For lump-sum investing, you make a large purchase order for the ETF you choose.
For dollar-cost averaging, you can set up a recurring, automated investment plan. Most brokers like Fidelity, Vanguard and Charles Schwab offer this feature. Newer apps like M1 Finance also are built around this concept, allowing you to automatically invest a set amount on a schedule into a pre-selected portfolio of stocks and ETFs.
For research and analysis, you can use a tool like PortfolioVisualizer to backtest hypothetical scenarios or Morningstar for in-depth fund analysis and ratings.
Frequently Asked Questions
Is it always better to invest with a lump sum?
Data suggests that lump-sum investing outperforms dollar-cost averaging most of the time, but it’s not always the best choice. The right strategy depends on your risk tolerance and emotional comfort level because a lump-sum investment has a higher risk of immediate losses if the market drops soon after investing.
How does dollar-cost averaging reduce risk?
Dollar-cost averaging reduces risk by spreading out your investment over time, which prevents you from investing all your money at a single market high. The strategy helps to lower your average cost per share and can ease the psychological stress of market timing.
What types of investments work best for these strategies?
Both lump-sum investing and dollar-cost averaging work well with low-cost, diversified exchange-traded funds that track broad market indexes. ETFs provide instant diversification and are suitable for either a single large purchase or recurring, automated investments through a brokerage platform.
