Which Investing Technique Can Get Me More More: Lump Sum or Dollar Cost Averaging (DCA)?

A Money Girl listener named Eric says, “I really appreciate listening to your show and all the great information you give. I have a question regarding contributions to my Roth IRA. Some argue it’s best to make equal monthly contributions to take advantage of dollar-cost averaging. Does it make a difference whether I contribute to my Roth IRA monthly or do one lump contribution yearly when I have the money to max out the account?”

Thanks for your great question, Eric! This post will answer it by reviewing what dollar-cost averaging (DCA) is, its pros and cons, and how it compares to investing a lump sum.

What is dollar-cost averaging (DCA)?

As Eric mentioned, dollar-cost averaging is investing a consistent amount at regular intervals, such as monthly or bi-monthly. It’s most commonly used for relatively volatile investments, like index, mutual, and exchange-traded funds (ETFs), where the price could be vastly different every time you intend to buy more shares.

If you’re enrolled in a workplace retirement plan, such as a 401(k) or 403(b), and have a flat amount or percentage of your paycheck getting contributed, you’re already dollar-cost averaging.

But what if you’re like Eric and have extra cash to invest in an individual retirement account (IRA), a self-employed retirement plan, or a brokerage? You can invest all of it at once or gradually by dollar-cost averaging.

Example of dollar-cost averaging (DCA)

For instance, let’s say you want to max out an IRA for 2024. You can contribute $7,000 or $8,000 over 50, and you have until April 15, 2025, to do it. 

If you’re under 50 and have $7,000, you could go ahead and contribute all of it, just like Eric is considering. However, perhaps you don’t want to risk investing it at once.

Instead, you could invest a steady amount, like $583 monthly.

Let’s say your investment is a mutual fund trading at $10 a share. By purchasing $583 of the fund, you’d buy about 58 shares. But if the fund increases to $12 the following month, you’d buy 48 shares. And if the price falls to $8 the next month, you’d get 73 shares.

What are the benefits of dollar-cost averaging (DCA)?

By sticking to a DCA strategy over the long term, you may cut the risk of market volatility. It helps smooth out how market fluctuations affect your investment portfolio, making you less vulnerable to bad market timing. In other words, if you invest a lump sum when a fund’s price is at an all-time high, you’d lose money and never have the chance to recover.

Plus, DCA can be easier on your budget if you typically don’t have excess cash to spend. It can also make investing less emotional if you’re more focused on how much to invest rather than on the price of an investment from week to week or month to month.

Once you choose an investment, it doesn’t matter what its price is because you regularly buy it, whether up or down.

I also like how a DCA strategy allows you to automate investing, keeping you on a predetermined schedule. That’s a great way to make investing a habit you will likely continue, even when an investment’s value drops. Instead, when a price falls, you see it as a chance to buy more shares.

In general, dollar-cost averaging is best for investors with a long time horizon who don’t don’t have a large lump sum to invest or want to worry about timing the market correctly, which is virtually impossible. You don’t need any experience or expertise to implement a DCA investment strategy.

What are the downsides of dollar-cost averaging (DCA)?

The downside of DCA is that you could miss out on a huge increase in an investment’s price compared to making a lump sum investment. Also, since the market generally rises over time, you could argue that investing a large amount earlier is better than investing smaller amounts over a long period.

In general, when the stock market is flat or declines, you’ll likely come out ahead with a DCA strategy. However, when the market goes up, DCA could be a disadvantage. Also, DCA doesn’t remove all investing risk; you must still identify suitable investments based on your risk tolerance, time horizon, and financial goals.

When should you make a lump sum investment?

Let’s get back to Eric’s question about whether he should make a lump sum Roth IRA contribution and max it out now. Eric, since the amount you plan to invest is relatively small and the market is generally doing well right now, I would max out your IRA with a lump sum contribution.

However, I’d favor a DCA strategy if you had just won the lottery and had tens or hundreds of thousands to invest. Knowing that you’ve maxed out your account can give you peace of mind that you’ve accomplished a significant financial goal. Also, investing the $7,000 now could prevent you from spending the money on something else.

This article originally appeared on Quickanddirtytips.com and was syndicated by MediaFeed.org.

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