Ask Wealthfront: Should I Dollar Cost Average?
Welcome to our Ask Wealthfront series, where we tackle your questions about personal finance and investing. Want to see your question answered here? Reach out to us on social media and we’ll try to address it in a future column.
If I have a large sum of cash to invest, should I invest it all at once or dollar cost average?
If you have a large sum of cash you plan to invest, there are three main approaches you might take. Let’s start by going over your options.
- Option 1: Lump sum investing. Invest the entire sum right away.
- Option 2: Dollar cost averaging. Invest a set amount of money on a predetermined schedule until you’ve invested it all. For example, you might invest $1,000 a month for five months instead of investing $5,000 immediately.
- Option 3: Market timing. Hold cash and wait for the “right” time to invest.
From the way you worded your question, it seems like you already know that market timing is probably a bad idea. It’s virtually impossible to accurately predict the best day to get in the market. We’ve written about this before, and encourage you to check out our blog posts about how waiting for the “right” time to invest can end up hurting you.
But what about lump sum investing versus dollar cost averaging? How should you decide? Below, we’ll break down the case for each approach so you can choose the approach that’s right for you.
The case for lump sum investing
There’s a strong argument to be made for investing your bonus, inheritance, or other excess cash immediately. Vanguard conducted research comparing the results of lump sum investing and dollar cost averaging, using MSCI World Index returns from 1976 to 2022. In their analysis, they found that lump sum investing performed better than dollar cost averaging (which, in their study, meant breaking investments up into three equal investments and investing them a month apart) after one year 68% of the time. Put more simply, this research suggests that lump sum investing is likely to yield better results than dollar cost averaging most of the time.
There’s a famous saying in investing that time in the market beats timing the market, and that’s the rationale behind lump sum investing. By investing all of your excess cash right away, you’re minimizing waiting (and time spent holding cash) and maximizing the time that your investments will have to potentially grow and compound. By maximizing your time in the market, you’re also likely to reduce your probability of loss, which generally trends down as your investing time horizon lengthens.
But some people find lump sum investing difficult on an emotional level. Even if you know that, in theory, your investments should be worth more in the future if you invest them all immediately, you might worry about picking the “wrong day” to invest and watching your investments lose a lot of value in the short term. If this sounds like you and you just can’t stomach the thought of investing your cash all at once, that’s where dollar cost averaging comes in.
The case for dollar cost averaging
Dollar cost averaging is primarily a behavioral tool to help you get a large sum of money in the market. By committing to investing a set amount of money on a regular schedule, you are spreading your investments out over time and eliminating the possibility that you will invest all of your money on the worst possible day. You can think of it as a form of diversification—dollar cost averaging is effectively diversifying your investments over time. As the Vanguard research shows, dollar cost averaging won’t necessarily lead to better returns compared to investing a lump sum immediately, but it is likely to outperform waiting around with all of your money in cash.
If you struggle with the idea of investing your cash immediately, ease in by breaking the larger sum up into equal parts and choosing an investing schedule you can commit to. Maybe investing $5,000 today and another $5,000 next week feels less risky than investing $10,000 today. Choose a schedule you can get comfortable with, keeping in mind that getting into the market sooner is generally better because it allows you to take advantage of the power of compounding.
A final word on dollar cost averaging to avoid confusion: In this post, we are talking specifically about a situation where you have a large amount of cash available to invest today. But dollar cost averaging is also commonly used in situations where investors regularly have a smaller amount of cash to invest on a set schedule—for example, $500 out of every paycheck. In those cases, we encourage investors to dollar cost average their excess cash into the market on a regular schedule and keep it up regardless of short-term market fluctuations. The key, again, is to minimize waiting. As our Chief Investment Officer Burt Malkiel and VP of Investment Research Alex Michalka wrote in a letter earlier this year, dollar cost averaging in this way in a volatile but flat market can be especially advantageous, because it can allow you make money even when the market doesn’t go up, because you have the opportunity to buy more shares when the market is down.
Key takeaways
The decision to invest a large sum of cash immediately or dollar cost average comes down to what you’re most comfortable with.
- Research from Vanguard suggests lump sum investing is likely to yield better results. But this approach can be hard to execute on an emotional level.
- Dollar cost averaging is a behavioral tool that can help you get in the market on a predetermined schedule. If you’re struggling to invest a lump sum, this can be a good approach. Dollar cost averaging is also a great approach if you regularly have a set amount of money to invest (like a portion of your paycheck) instead of a large, one-time windfall.
We hope this information helps you feel confident as you make a plan to invest your excess cash!