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Lump Sum vs Dollar Cost Averaging. THIS Is What You Should Know

This is a dilemma faced by many investors of all experience. Being unsure if you should invest one lump sum, or spread out the risk via average cost investing (better known as dollar cost averaging) is a common headache.

 

Do you really need to choose?

First and foremost, it is important to debunk the myth that you must choose either one of the two investment types. To manage risks, you can do both concurrently, or even alternate between the two depending on your risk appetite, market confidence, capital available and more. With that out of the way, let us move on to look at the pros and cons of lump sum and average cost investing.

 

Importance of Market Timing & Risk

Market timing is arguably the most important factor in determining your return on investment. In an ideal scenario, you should invest a lump sum at the assets’ lowest and sell at its highest to maximise profits. By doing this continuously, you will be able to leverage on the uptrend, and prevent losses during a downtrend. By buying low and selling high, you can potentially outperform average cost investing. Unfortunately, as you can imagine, this is difficult.

Even if you are skilled at analysing historical data or predicting market sentiment based on publicly available qualitative information, you will still be unable to determine the highs and lows with accuracy. While it is tempting to do a lump sum investment, especially if you have just received an endowment fund, a pension, or even your annual bonus and Annual Wage Supplement (AWS), beating the market is often difficult and requires risk to be taken.

In such situations in which the investor is uncertain or unwilling to take the risk, using a dollar cost averaging method may be more suitable. By doing so, you can reduce the risk of entering the market at the wrong time. You need not keep your eyes glued to the monitor to watch the ups and downs. In addition, it also requires a much lower starting capital as it typically costs S$100 a month. You can also enjoy the added convenience of deducting it automatically from your bank.

What many forget is that a flexible buying arrangement is often possible. By exercising your own judgment after doing your own research, you can opt to purchase more when you feel like the price is at a bargain, and to buy lesser (minimally S$100 in most cases) when you feel that the price is high. If you are the type of investor who prefers more engagement and involvement with your assets, this flexibility is definitely an added bonus. Of course, by changing how much you invest in every month, you may also subject yourself to erroneous judgment.

But don’t forget the transaction costs…

With that being said, average cost investing generally incurs more transaction fees since you have multiple transactions spread across the investment period. As you are spreading a lump sum over a long period of time, the money that is waiting to be invested is sitting there, waiting to be invested. In fact, determining how long you want the money to be spread over is a big issue in itself. If you spread it for more than two years, you may miss the general upswing in markets as inflation can eat the real value of cash. While average cost investing lowers the risk of entering at a bad timing, your returns will likely not be as high as a lump sum investor who entered at the right timing. Essentially, you lower the chances of you making a big loss, but you also lower your chances of making a big gain as well. It is also important to note that the cost benefits of dollar cost averaging has a tendency to diminish over long periods of time as time alone can already average out the market’s ups and downs, making your investment method less effective.

If you are a budding investor, or if you have been wanting to invest but never made it to the actual purchase despite having researched and educated yourself well, adopting a dollar cost averaging method may be a good start to get the ball rolling. After all, you usually have the option to stop whenever needed. This method may also allow you to beat advanced investors. You can then do lump sum investing on the side. One thing to note is that many tend to forget about their monthly automatic investments as not much active planning or capital are involved in the process. As the investor, not much may go into the investment emotionally since the process is automated. It is therefore important to not forget or disregard your investments as they do build up over time.

Regardless of your investment preference, you should try not to sell or pull out of the market at every small swing or downturn. Understanding that corrections occur is important. Unless you are highly experienced or transact in huge volumes, ignoring tiny corrections will not harm your portfolio. In addition, do not forget to add transaction costs when calculating your profit or loss.

Make the best decision for yourself

After doing your due diligence and seeking help from your portfolio manager or support group, you may have ample historical data on past index performance that can serve as a general guide for your decision. There are also various calculators available for free online, but none of them can give assure an accurate prediction of the market as it relies on historical data and judgment. Ultimately, you need to decide what works for yourself.

 

Read our other investment articles:

Dollar-Cost Averaging: a completely risk-free investing strategy?

6 Tips For Stock Investment That Even Seasoned Investors Don’t Know About

A Workshop That Taught Me To Invest In Value

(By Vanessa Ng)

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