If you are a beginner investor and are about to make your first investment in the stock market, you may be wondering if you should invest a large portion of money immediately, or invest a little money over an extended period of time.
When you are an investment beginner, it can be normal to have $10,000, $50,000, maybe even $100,000 to invest. If you find yourself in this situation, you are probably trying to figure out how to invest a large sum of money.
To invest a large sum of money at once is referred to as a lump sum investment.
For example, if you decide to invest a large sum of money and do a lump sum investment, you may have $24,000 of cash to invest. You may decide to invest this entire amount at once.
However, if you wish to invest this large sum of money over a fixed amount of time, this is referred to as dollar cost averaging.
For example, if you decide to dollar cost average the $24,000, you may decide to invest $2,000 per month on the 1st of the month for 12 months.
Many financial advisors and media outlets tout the need for dollar cost averaging large sums of money. It is partly with good reason, and, perhaps, partly with negative consequences.
It turns out if you have a large sum of money when starting investing, dollar cost averaging will likely lead to a lower rate of return compared to investing a lump sum. And, while this is true, dollar cost averaging may still be worth if from a behavioral finance point of view.
In this article, we will be discovering whether a beginner investor should dollar cost average a large sum of money, or do a lump sum investment.
Related article – Beginner Millennial Investing – 11 Steps to Start Investing in the Stock Market
The market is usually up
It is true that most of the time, the stock market tends to be increasing in value. This makes sense, of course, because the entire concept of business is to make profit. The collective businesses and industies across the United States have one purpose – make as much profit as possible.
This is capitalism, and, for this reason, business have produced profits on average, not losses. Those profits have mostly led to positive gains in stock prices, just as they should.
According to Andrew Sather, “The percentage of stock market days up from ‘96 – 2016 was 53.29%. The percentage of stock market days down was 46.71%.” As we can see here, the stock market has increased 52.29% of the time, and decreased only 46.71% of the time.
According to work by Nathan Faber, of a 92-year period, “…from 1926 to 2017, the market has had positive returns over 74% of the rolling 12-month periods.”
Think about that – this year, no matter when you add money to your investments, you have less than a 46% chance the investment will decline that day, and if you go way back, it will decline less than 25% of the time over a rolling one-year period.
Another shocking statistic, according to Base Hit Investing, when analyzing the past 189 years of stock market returns, “…the market was 5 times more likely to be up 20% or more in a year (50 out of 189) than down 20% or more in a year (9 out of 189)!”
I think you get the gist so far, the stock market is more often increasing in price than decreasing in price. This is a key to understanding why dollar cost averaging a large sum of money will likely lead to a lower return.
The benefits of lump sum investing are highly correlated with stock market returns
If we think about how the market has far more up days than down days, we start to realize how dollar cost averaging a lump sum may lead to lower returns.
According to Nathan Faber, “The average outperformance of the LSI [lump sum investment] strategy was 4.1%, and as expected, there is a strong correlation between how well the market does over the year and the benefit of LSI.”
Faber shows the following chart from the Kenneth French data Library and Robert Shiller Data Library
If you are confused by this chart, it is just showing a high correlation between lump sum investments outperforming dollar cost averaging when the S&P 500 has a positive return. And, as we learned above, a positive return is far more likely than a negative return in the stock market.
For this reason, it turns out that dollar cost averaging underperforms lump sum investing. This can be seen from this chart from Faber:
As you can see, the lump sum investment outperformed the dollar cost averaging a whopping 68% of the time and underperformed 32% of the time!
Now, after seeing this data, I like my chances when it comes to lump sum investing a large amount of money.
Faber even shows the results compared to the MSCI Japan Index, which has seen an extremely rough economic cycle for almost thirty years compared to the S&P 500.
Even when comparing an index like the MSCI Japan, with far less up days than down days compared to the S&P 500, the lump sum was still close to the dollar cost averaging results. As you will see in the image below from Faber, the rolling 12-month lump sum was up 49% of the time compared to the dollar cost averaging of 51% of the time.
This leads me to believe there is a high chance of outperformance for a lump sum investment of a large sum of money.
By the way, I think you should consider using M1 Finance when you start investing, here’s why! M1 Finance Is Now Free?! No More Fees for the Best Robo-Advisor App
Blending these results with behavioral finance
This data is pretty amazing to me. I had been under the impression that dollar cost averaging large positions into investments should lead to higher gains.
Now that we know dollar cost averaging tends to underperform lump sum investments on average, we should talk about the psychology of investing before we make a decision of what strategy one should take.
Loss aversion
Loss aversion can be described by the following: “It is thought that the pain of losing is psychologically about twice as powerful as the pleasure of gaining, and since people are more willing to take risks to avoid a loss, loss aversion can explain differences in risk-seeking versus aversion.”
If we incorporate loss aversion into the idea of dollar cost averaging vs. lump sum investing, we may come up with another approach to whether we should dollar cost average or not.
On the one hand, we have a better chance of gaining more by making a lump sum investment when we start investing. On the other hand, if we do happen to invest our lump sum at the unfortunate time of a market decline, the loss may be felt twice as much as the potential gain we hoped to experience.
A lot of what I write is geared toward the beginner investor, or, at least, those who do not consider themselves experienced investors. My thought for those who are taking a do-it-yourself approach to investing, or a passive investment strategy, is that dollar cost averaging may be better from a psychological standpoint, but not from a rate of return standpoint.
Basically, I don’t believe you will feel the pain of loss as much if you dollar cost average.
If you are a beginner, you do a lump sum investment, and the market suddenly declines – there is a good chance you will become “startled” and sell your investments. Because you feel the pain of loss twice as much as the joy of gain, selling can be dangerous to your return.
On the other hand, if you start dollar cost averaging during a market decline, you may only have a small portion invested as the market starts declining. You can continue to dollar cost average as the market declines, and this may lead you to stay invested, instead of pulling out your investments.
For those who are experienced investors and understand the dangers of trying to time the market, the lump sum strategy may be the way to go.
Dollar cost average your savings
This article is meant to help you decide whether to dollar cost average a lump sum when you start investing, or whether you should dollar cost average when you start investing. You may, however, find yourself asking yourself if you should dollar cost average your savings each month, or if you should also do a lump sum investment. You may be thinking of saving up a certain amount of cash before you invest, or you may be thinking of only investing your cash once per year.
Since the market has more up days than down days on average, it is better to invest your savings each month. If you wait to do a lump sum investment, you are more likely to miss out on those up days by waiting. At the same time, waiting to invest until you save up a lump sum will increase your susceptibility to loss aversion. This is because you will be making a lump sum investment and increase the risk of pain felt if the market declines after your investment.
If you are not sure whether to invest your savings each month or save a lump sum and invest it all at once, the answer is to dollar cost average your savings.
What’s the answer? Should you dollar cost average or lump sum invest a large sum of money?
It really comes down to the idea of whether you would sell your investments if the market declines after you invest a large sum of money.
If you invest a lump sum of money and the following month the market begins to decline, say, 5%, 15%, 25% etc…, would you sell your investments? Or, would you leave your investments alone knowing that over long periods of time, the stock market averages positive returns?
If you can honestly tell yourself you will keep your money invested, go for the lump sum. However, if you are an investment beginner, you should dollar cost average a large sum of money so you can avert the consequences of loss aversion.
Either way, I hope you learned something from this article…I know this information led me to a personal realization about dollar cost averaging!
Thanks for reading!
If you liked this article, you may also like 5 Common Investment Mistakes Made by Beginner Millennial Investors.
Disclaimer: These are the ideas and opinions of the author. The author is not responsible for the actions of those who read the posts on this blog. Each individual reader has a unique situation and unique needs. This blog is not intended to solve those unique situations of the readers. This blog is not liable for decisions made by the readers of this blog.
