Dollar Cost Averaging versus Lump Sum investing

We have seen earlier the proposition for “Time in the Market” being more effective than “timing the market” for ordinary folks like yourself and me. While waiting on the sidelines for entry opportunities, you may miss out on both dividends and potential capital gains.

The market is uncertain, unpredictable and with combinations of long bull and bear markets, it can remain irrational longer than you can remain solvent. Say you have a sum of money with a long-term investment horizon. Would you choose to execute Dollar Cost Averaging or Lump Sum investing?

Dollar Cost Averaging simply means investing a fixed sum of money, usually common stock, on a regular basis regardless of how the market is performing. The frequency can be monthly, quarterly, semi-annual or even annually. As a result, when the price falls, more shares could be purchased and vice-versa when it rises. Lump Sum investing is done by investing the entire sum all at once without breaking it down into smaller portions.

We use the same illustration of the performance of Overseas Chinese Banking Corporation (OCBC: O39) over the past 19 years – 2000 to 2019.

Consider two investors, Investor A who carries out Dollar Cost Averaging of $1000 monthly and Investor B who does Lump Sum investing of $12,000 every start of the new year.

In the same time period, Investor A ends up with 20,210 shares while Investor B ends off with 22,962 shares. A difference of 2751 shares between them.

Research from Vanguard has shown that investors tend to fare better with Lump Sum investing most of the time. Why? Markets tend to go on the uptrend roughly three out of every four years. By comparing the performance of their 60/40 stock/bond portfolio in the U.S., U.K. and Australia, an immediate Lump Sum investment over a year beat Dollar Cost Averaging (spaced into 12 monthly investments) about two-thirds of the time, by an average of 1.5% to 2.4% depending on the country. Results were even more pronounced for longer time horizons.

However, the downside is that the volatility of the Lump Sum investment is much higher as compared to Dollar Cost Averaging.

Over a rolling 12-months, the number of shares bought with Dollar Cost Averaging range between 2106 to 2332 shares. The same sum bought with Lump Sum investing range between 1705 to 3834 shares depending on the price month ($7.04 versus $3.13 share price).

The difference between the worst-case and best scenarios was much larger for Lump Sum investing as compared to Dollar Cost Averaging strategy. You can either win big or lose big at the same time.

Sometimes, the behavior of people investing in the stock market is driven by their emotions. Holding too much cash can become unbearable for investors who do not have a game plan for deploying capital. Market crisis just do not operate on a set schedule.

Investors have to constantly to ask themselves which outcome would they regret more — missing out on potential gains or raking in potentially large losses? Although Lump Sum investing may have the highest probability of success, Dollar Cost Averaging offers the biggest payoff both psychologically and from market perspective. For decreased exposure to market volatility and better sleep at night, Dollar Cost Averaging serves for a smoother ride and lower probability of large losses.

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