Wednesday, March 07, 2007

Investing 101 - Lump Sum Performs Better Than Dollar Cost Average

In Make IRA and College Fund Contributions in January, I shared the benefits of making my entire 2007 529 Plan (college savings account) and 2007 IRA contributions in January. Several readers questioned whether it was prudent to invest a lump sum contribution, given the risk of a short term downturn in the market. (An even more appropriate question given the market results for the past week:-)

I recalled, but could not find, an article that concluded even if one had invested at the S&P peak every year, one would still have good investment returns. However, I did find this article, Lump Sum Beats Dollar-Cost Averaging, which share an analysis that shows lump sum (LS) investments beat dollar-cost averaging (DCA) about 60% of the time from 1926 to 1991. This difference was statistically significant. Based on this information, The Sun's Financial Diary did his own analysis and concluded that not only did DCA have lower returns, but that the volatility with DCA was also higher.

As it turns out, the further analysis shows that investing one's money as soon as possible is the right strategy. This is true primarily because the markets have been rising over the long term since 1926. So waiting to invest LS will likely return less that DCA. Of course, if the market should to into a prolonged decline (20+ years), the results of the study will no longer hold true.

On the other hand, dollar-cost-averaging significantly reduces the impact of market risk versus a single purchase. For instance, if one had invested LS versus 1/12 the amount in a monthly DCA prior to decline on February 27, 2007, the market impact on your entire investment woudl have been very bad. This phenomena is discussed in Dollar Cost Averaging - A Technique that Drastically Reduces Market Risk. Also, psychologically, it feels less risky to use DCA since DCA enables one to benefit should there be a drop in the market, as there was last week.

Net, one needs to use the strategy with which one is most comfortable. However, the data show, that one needs to be invested, whether that be using LS or DCA. Otherwise, one risks missing out on the long term trend of a rising stock market.

This is not financial advice. Please consult a professional advisor.

Copyright © 2007 Achievement Catalyst, LLC

1 comment:

Sun said...

Hi Super Saver: Thanks for the mention. I think your conclusion of "investing one's money as soon as possible is the right strategy" says it all: It doesn't really matter how much one invests as long as he/she starts investing right away when the money is available instead of wait and see.

BTW, how's your "bad, bad investment" going? Any luck? I am glad somebody finally won it so I don't have to keep throwing money away :D.