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How Dollar-Cost Averaging Can Help Investors Get Into the Market Thumbnail

How Dollar-Cost Averaging Can Help Investors Get Into the Market

As with many things in life, knowing what we’re supposed to do and actually doing it are two separate things. This is true for our health, relationships, careers, and of course, our finances. When it comes to investing, it’s well known that properly diversifying and staying invested are the best ways to achieve long-term financial goals. However, this is often easier said than done, especially when market and economic outlooks are uncertain, as they have been for many years. Fortunately, there are investment methods for managing the emotions that come from market volatility. What should investors know about how they can stick to an investment plan through years and decades?

Dollar-cost averaging and lump sum investing

Navigating the stock market can be difficult, particularly if you unexpectedly receive a significant amount of money from sources like an annual bonus, the sale of a business, or an inheritance. While smart long-term investing can transform savings into considerable wealth, short-term market fluctuations can unsettle even the most determined investors.

Dollar-cost averaging (DCA) can be a valuable strategy in this context. DCA involves regularly investing a fixed amount of money at set intervals, helping investors avoid the temptation to react to every market change or attempt to time the market. If you already contribute automatically to your portfolio with each paycheck, such as through a 401(k) plan, you are already using a form of DCA. The frequency of these investments—whether monthly, quarterly, or annually—matters less than the consistency of the approach.

Conversely, investing a lump sum all at once depends heavily on the market's immediate performance following the investment.

As illustrated in the chart above, the hypothetical returns of these two strategies starting in 2000 show notable differences. A $100,000 lump sum investment in the S&P 500 would have experienced an initial loss due to the dot-com crash, eventually recovering over several years until the housing market crash. The investment value would have fully recovered in 2013 when the S&P 500 reached new highs, subsequently benefiting from the prolonged bull market.

The chart also depicts the hypothetical returns of a dollar-cost averaging strategy, where the $100,000 is invested in smaller monthly increments over the same period. While this example spans an extensive time frame, it underscores important points.

By investing monthly, dollar-cost averaging would have minimized early market downturns, as the portfolio would largely remain in cash, maintaining stability through the mid-2010s. Later, the lump sum investment would catch up and outperform due to the strong bull market. Both strategies have shown their advantages and periods of success over the past twenty-five years.

Understanding these investment methods allows you to make choices that align with your financial objectives and risk preferences.

Dollar-cost averaging can make it psychologically easier to invest

The key takeaway is not just about maximizing returns but also about maintaining your investment over years and decades. Dollar-cost averaging (DCA) helps to mitigate risk during periods of sharp market declines, particularly early in the investment period. On the other hand, lump sum investing often yields higher returns in the long run, given that markets have historically trended upwards over time.

This comparison is similar to evaluating a 100% stock portfolio against a well-diversified one that includes a balanced mix of stocks, bonds, and other asset classes. A portfolio entirely composed of stocks might outperform over extended periods, especially during strong bull markets like the current one, but it will also face more significant downturns. Conversely, a diversified portfolio offers steadier growth and smaller declines, making it easier for investors to remain calm.

This perspective is particularly relevant now, with the market hovering near all-time highs. The reality is that market conditions are always uncertain. Whether it's the upcoming presidential election, geopolitical tensions, or fluctuations in interest rates and the economy, investors often worry about a potential market pullback right after they invest.

It's crucial to remember that a market being near its peak does not necessarily indicate an imminent pullback. During bull markets, it's common for markets to reach numerous new all-time highs. Despite the significant uncertainty this year due to interest rates, inflation, and Federal Reserve policies, the S&P 500 has already set 24 new all-time highs, including a strong rally in May following an April slump.

Ironically, investing can be psychologically challenging both when the market is rising, for fear it is at its peak, and when it is falling, for fear it may drop further. Therefore, whether dollar-cost averaging or lump sum investing is more suitable depends on the individual investor's risk tolerance and investment horizon.

Getting invested sooner is better than waiting for the right timing

Whether you choose to dollar-cost average or invest all at once, getting into the market sooner has historically been better than “waiting for a pullback.” As the accompanying chart shows, waiting for a better time to buy or trying to “buy the dip,” has tended to backfire. Since the market tends to rise over time and can rebound unexpectedly, even the worst timing is often better than being out of the market.

For example, an investor waiting for a 5% pullback before investing would, on average, have waited 291 days. Even though 5% or worse pullbacks do occur periodically, the fact that the market rises over time means that there are often “higher lows” – i.e., the next dip is higher than before. Historically, markets have gained a whopping 13% during these periods, a figure which includes the pullback itself.

Just as a diversified portfolio can help reduce overall risk and volatility, so can dollar-cost averaging when it comes to investing over time. Dollar-cost averaging may not be the mathematically optimal way to invest, since lump sum investing has tended to outperform over history. However, it can help investors to stay focused on the long run without worrying about every market event or trying to time the market perfectly. As is always the case, seeking the guidance of a trusted financial advisor is the best way to determine the approach that works best for your specific goals.

The bottom line? Dollar-cost averaging and lump sum investing are both ways to invest cash. History shows that getting invested sooner is the most important way to achieve long-term financial goals.