I get this question once in a while about the best way to deploy one’s investment capital into the stock market, and especially for the purpose of long term investment in an index Exchange Traded Fund like STI ETF.
Should an investor invest in one lump sum?
Or should the investor spread out the capital by investing a smaller amount on a monthly basis?
Financial advisors often touted the Dollar Cost Averaging (DCA) as a superior strategy to lump sum investment. The reason they usually give is that the same amount of capital can buy more shares or units when the prices declined. Overtime, the average purchase price would be lower.
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Is this true?
This study done by Vanguard tell us that Lump Sum Investment (LSI) is better two-thirds of the time while DCA performed better merely one-third of the time.
Sparing you from reading the whole paper, the gist of it is to tell you that
- Lump Sum Investment is better in a rising market
- Dollar Cost Averaging is better in a down trending market
- Because historically market rises most of the time and collapse infrequently, LSI fared better than DCA
The findings can be understood in an intuitive manner – think of these scenarios:
In a rising market where share prices are increasing,
- A lump sum investment will put all the capital at work immediately and reap the potential gains
- DCA would result in buying lesser shares at higher prices as market trends up
In a downtrending market where share prices are decreasing,
- A lump sum investment will attract the biggest lost while
- DCA would continue to buy more shares at cheaper prices as market declines
Hence, it boils down to whether you are bullish or bearish about the market. But I will advise you not to rely on your intuition because most investors cannot accurately predict the market direction. As such, knowing this may not be helpful to investors at all.
The decision to do an LSI or DCA should not rely on the market direction, but the availability of capital. If you are starting your career and have not much capital to begin with, one should do DCA. It is a disciplined way of building up investment capital. If you have already accumulated a sizeable capital after years of employment, you should consider LSI, this should work better for you two-thirds of the time.