You have some money saved up and you have decided to invest. You already know what you want to invest in, but you now face another decision: when should you invest it?
Do any research on the subject, and you’ll likely come across two major strategies: lump-sum investing and dollar-cost averaging. But what exactly are these approaches, and how do they fit into your overall investment strategy?
Dollar-cost averaging (DCA) involves investing a certain amount of money at regular intervals, regardless of share price or market performance. For example, an investor could purchase $100 of a certain security every week for a year. This results in the investor purchasing more shares when prices are lower, and fewer when prices are higher.
DCA allows individuals to invest without worrying about short-term volatility or trying to time the market. Because it’s nearly impossible to predict short-term spikes and dips in the market or individual share prices, DCA investors instead opt to receive the average share price over the selected time period. This also lessens frustration if the investment dips right after purchase.
Lump-sum investing, on the other hand, is pretty much exactly what it sounds like: investing a larger sum of money all at once. Instead of the $100 a week for a year, the lump-sum investor puts all $5,200 to work immediately.
The idea behind lump-sum is that markets tend to move up over time, so it’s best to invest more money upfront. Lump-sum investing also allows more time for an investor’s money to gain value. Money earns very little (or nothing) if it sits idle, just waiting to be invested. It's better to put it to work from the get-go. As the old adage says, time in the market is more important than timing the market.
What's the answer?
Hindsight is 20/20. It's easy to know in retrospect which choice would have produced a better outcome — simply run the numbers to see which option led to more money. Unfortunately, we have to make the decision now, not in the future. Successful investing is about choosing the path that gives you betters odds of success. Historically, the choice that provides you a higher likelihood of success is clear: lump-sum investing.
That's because, more often than not, today's price will be lower than the average price from now until a certain time in the future. The likelihood of this being true increases with the time frame.
The problem with DCA and lump-sum, however, is that they are both strictly textbook examples. The real world doesn’t always work in such a by-the-book way.
Both strategies assume you begin with a significant chunk of change to invest and never get another dollar. But how often do you really receive a large sum of money to invest all at once? In reality, income tends to trickle in over time, meaning you likely won’t have all the money you want to invest all at one time.
So where does that leave us?
It's best to practice the following habit: invest your money when you have it. This take principles from both lump-sum investing and DCA.
Like lump-sum, this assumes today's price is likely lower than it will be in the future. It's expensive to wait and do nothing, and it's too difficult to time the market and try to purchase at the absolute low. So, better to put your money to work as soon as possible.
With respect to DCA, it assumes you'll have extra money come in over time. You may invest a fixed dollar amount with each paycheck or, better yet, a certain percentage of your paycheck (which benefits your savings with every raise). The consistency and regularity takes the emotions out of investing and you buy into your investments at their average price over time.
This approach is the driving force behind the M1 Finance platform. But we also take it a step further: rather than investing a fixed amount in individual securities, deposits flow into your entire portfolio. I call this portfolio-cost averaging, since you buy more of a certain security when it has underperformed on a relative basis.
Here’s how M1 helps you get the most from this strategy:
• Automated deposits: Set up scheduled, recurring deposits to your investment portfolio. This ensures you won’t have to do this step manually every time you want to invest. We recommend a schedule that coincides with your paydays, so your money starts working for you as soon as you earn it.
• Fractional shares: Because portfolio-cost averaging takes a page out of the DCA playbook in that it involves investing a fixed amount at set intervals, you’ll need a platform that offers fractional shares. This way, no money will sit idly in your account and every penny of your deposit will go to work in your portfolio.
• Dynamic Rebalancing: M1’s Dynamic Rebalancing is a form of automatic rebalancing in which money is intelligently deployed in your portfolio to keep your portfolio on track with every deposit. This means every deposit not only increases your potential for returns, but also plays a role in maintaining your target asset allocation.
• Free trades: M1 doesn’t charge commissions or management fees, so you can invest as often as you’d like without paying for trades. Translation? You keep more of your money.
Have you used any of these strategies before? How did it work out? Send us a tweet to let us know at @M1_Finance.
Learn how M1 is the perfect ShareBuilder alternative when it comes to dollar-cost averaging.
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