If you have the cash to invest, should you dump all of it into the stock market at once, or spread it out over time?
It’s been a fierce debate on Wall Street for decades, especially now that “buy the dip” – a strategy in which investors buy up shares after they have dropped in price – has shown signs of fraying recently. This comes after that behavior among retail investors helped propel stocks higher for months following last year’s pandemic-fueled sell-off.
Turns out, investing all of your money right away (lump-sum investing) historically leads to better returns over time versus a slow-and-steady approach with smaller increments invested in that span (dollar-cost averaging), according to recent research.
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But throwing a pile of money at the market all at once, which is essentially what the “buy the dip” strategy is, and letting it sit for years, isn’t as easy as it sounds. That’s because it comes with a number of caveats and risks, financial experts say.
The S&P 500, widely used by mutual funds as a proxy for the stock market, has grown an average of 8% a year since 1990, according to Ally Invest. But it’s endured double-digit gains and losses over those years.
So trying to time the market runs the risk of missing out on periods of exceptional returns.
“Lump-sum investing tends to perform better than dollar-cost averaging over time, but it’s inherently more risky,” says Callie Cox, a senior investment strategist at Ally Invest.
“If you’re throwing all of your money in the market, of course you’re going to have more of an emotional attachment to it and naturally feel more anxious. It also leaves you up to the market’s whims.”
Dollar-cost averaging vs. lump-sum investing
Many Americans tend to gradually put their money in the stock market instead of trying to time the next top or bottom. That’s a strategy called dollar-cost averaging, where investors put money in the market over time at set intervals.
It’s an approach that billionaire investing legend Warren Buffett has long advocated because it typically rewards consistency over timing. Owners of 401(k) plans, for instance, are using this strategy through their paycheck contributions.
Investors who opt for the lump-sum strategy hope to put their money to work immediately and take advantage of future market growth. They’re banking on history, which shows that stock market returns exceed those of bonds.
“Buying the dip is essentially market timing,” Cox says. “That’s the thing money experts will say not to do.”
Buffett, the chairman and chief executive of the conglomerate Berkshire Hathaway, made his stance clear at the company’s shareholder meeting in May.
“If you like spending six to eight hours per week working on investments, do it. If you don’t, then dollar-cost average into index funds,” Buffett said. “This accomplishes diversification across assets and time, two very important things.”
Which strategy is a better way to enter the market?
Ally Invest crunched the numbers to see which method worked better over time.
Here’s a hypothetical situation: Say you have $10,000 to invest in a no-fee fund tracking the S&P 500. Should you invest $100 on the first day of every month for 100 months (or about 8½ years), or put all of the $10,000 in the market on the first day of the next month, then let it ride for 100 months?
Ally Invest ran all 100-month periods since January 1950 to see each strategy’s success over time. In this scenario, lump-sum performed better 85% of the time compared with dollar-cost averaging, the data showed.
But lump-sum investing works best when there isn’t a market downturn right around the corner, Cox explains. Much of your risk is concentrated in the day you pick to invest, whereas dollar-cost averaging makes it easier to spread out risk over time, she adds.
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There are times, however, when dollar-cost averaging is the better strategy.
In Ally Invest’s analysis, dollar-cost averaging beat lump-sum investing by the widest margin when the investing period started around a peak.
For those who are convinced this is the top, staying out of the market could get expensive, Cox pointed out. If you’ve waited for a pullback bigger than 5% before investing, you would have missed the S&P 500’s 30% rally from November until late September.
That means investors who had been waiting to put money to work once the markets saw a moderate or severe decline would have missed out on hefty gains. And some investors may use waiting to “buy the dip” as a crutch to not invest.
So which strategy should you use?
Dollar-cost averaging is a good strategy for investors who can’t stomach a lot of risk, according to Cox.
For instance, if you have a lump sum of money to invest and you put it into the market all at once, then you run the risk of buying at a peak, which can be unsettling if prices fall.
The potential for this price drop is called a timing risk, Cox explained.
Here’s an example: If you dumped your $10,000 into the market in November 1990, which was before one of the longest bull markets in history, your money more than quadrupled over the next 100 months, according to Ally Invest.
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.
Even for the most experienced traders, timing the market is difficult. So investors should avoid those impulses, financial experts say.
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In fact, the stock market’s best days typically follow its biggest drops, which means that panic selling can lead to missed opportunities, according to recent data from Bank of America.
If you’re worried about a sell-off, dollar-cost averaging could be a way to ease your anxiety about investing at record highs.
“It’s important to remember that investing is not an all-or-nothing pursuit,” Cox says. “If you’re worried or anxious about the market’s future, dollar-cost averaging may be the better strategy for your sanity.”
This article originally appeared on USA TODAY: Is ‘buy the dip’ a good investing strategy? Here’s why dollar-cost averaging may be better