It’s a nerve-racking time to invest.
The market is near all-time highs while Wall Street is getting more cautious by the day. It’s tough to go all in on this market with high uncertainty and low conviction, yet you’re feeling FOMO (fear of missing out) and prices keep rising.
What do you do? The answer may lie in how you invest your money, not what you invest in.
The world tends to frame investing as an all-or-nothing pursuit. You’re either all in and bullish, or on the sidelines with no skin in the game. But in reality, many people tend to gradually put their money in the market based on the calendar, instead of trying to guess the next top or bottom. That’s a strategy called dollar cost averaging, and it rewards consistency over timing.
And if you’re worried about a market meltdown, the gradual approach could be a wise way to calm your nerves while staying invested.
So, take a deep breath, and let’s talk about dollar cost averaging.
“All at once” (lump sum) versus “a little at a time” (dollar cost averaging) is a decades-old debate in the stock market.
To settle it, let’s walk through a little thought exercise.
A genie appears and offers you $10,000 to invest in a hypothetical, no-fee fund tracking the S&P 500. You have two choices:
1) Invest $100 on the first day of every month for 100 months (or about eight and a half years).
2) Put all of that $10,000 in the market on the first day of the next month, then let it ride for 100 months.
Tough choice, I know. We ran the numbers on all 100-month periods since January 1950 to get a better sense of each strategy’s success over time.
Investing all at once (the “lump sum” approach) performed better 85% of the time in this hypothetical compared to a little at a time (the “dollar cost averaging” approach). In a market that has generally gone up more than it’s gone down over the years, it’s been ideal to invest as early as possible. That’s especially true the longer you invest.
On paper, the answer seems obvious. In reality, though, it’s not as easy to dump all your cash into the market and let it sit for years.
Why? Stocks don’t move in a straight line. Sure, the S&P 500 has grown an average of 8% a year since 1990, but it’s endured years of double-digit gains and losses to get here.
Lump sum investing works best when there isn’t a market downturn right around the corner. Sure, if you dumped your $10,000 into the market in November 1990 – before one of the longest bull markets in history – your money more than quadrupled over the next 100 months. But if you invested $10,000 in October 2000 – right after the tech bubble burst – you lost nearly half of that over the same period.
The bad news? Nobody knows what the future holds. And if you’re convinced this is the top, staying out of the market could get expensive. If you’ve waited for a pullback bigger than 5% before investing, you’ve missed the S&P 500’s 20% rally over the past 10 months.
In lump sum investing, much of your risk is concentrated in the day you pick to invest. Compare that to dollar cost averaging, in which it’s easier to spread out your risk over time. It’s like diversification of your time. With dollar cost averaging, you may invest at higher prices, but chances are you’ll get a crack at lower prices as well. In fact, in our analysis, dollar cost averaging beat lump sum investing by the widest margin when the investing period started around a peak.
Dollar cost averaging could be good for your sanity as well. If you’re not risking as much cash up front, you’re less likely to stress over up and down days. Dollar cost averaging also naturally eliminates some of the mental barriers around investing. It’s easier to follow steps to a goal if they’re already laid out for you.
Of course, an investing strategy is only as good as the investor behind it. Dollar cost averaging works best if you’re able to consistently invest. That can be easier said than done. Life happens, and the case for dollar cost averaging can even become blurry in an economic downturn when conditions feel uncomfortable.
The Bottom Line
There are a bunch of pros and cons to consider in the lump sum versus dollar cost averaging debate. Ultimately, how you invest your money is a personal decision, and you know what’s best for your wallet. But if you’re worried about a selloff, dollar cost averaging could be a way to ease your anxiety about investing at record highs.
One thing’s for sure: Holding too much cash can be dangerous in a market known for its fierce rallies, so it’s important to have a plan.
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As senior investment strategist for Ally Invest, Callie Cox helps educate Ally Invest customers about the financial markets through engaging content and strategic initiatives. Callie has worked in financial research for her entire career, with stints at LPL Research, TABB Group and Bloomberg. Her work has been featured in Bloomberg, the Financial Times, Yahoo Finance, and Barron’s (among other publications). You can also find her on Twitter at @callieabost.