Let’s say you just inherited $10,000 on January 1, 2011 from your Great Uncle Herbert. Uncle Herbert may have been quick to lecture and always smelled like icy hot, but he was a financial whiz who knew how to save and invest. In his will, smelly Uncle Herb put one condition on your inheritance. You had to invest your money for at least 20 years. He wasn’t completely controlling, so he let you decide between two investment strategies: Lump Sum or Dollar Cost Averaging.
Choice #1: Lump Sum
Lump Sum investing is exactly what it sounds like. If you choose this strategy, you must invest all $10,000 on January 1, 2011.
Choice #2: Dollar Cost Average
Dollar Cost Averaging is putting a set amount of money into the market at a predetermined interval for a certain time horizon. The premise behind this strategy is that your money buys more shares when the price is low and less shares when the price is high. If you choose this strategy, you must invest the same amount on the first of each month for one whole year.
n 20 years, which investment strategy do you think comes out ahead?
Well, there is no way to know for sure unless you’re Michael J. Fox, and back from the future. But using historical data from 1950 to the present, odds are that the Lump Sum strategy outperforms the Dollar Cost Averaging strategy. (Of course, past performance isn’t an indicator future performance.)
If you would like to run the numbers, you can do so quite easily using the calculator and data created at MoneyChimp.
The problem is, most of us don’t have large sums of money sitting around waiting to be invested. And by piling up cash for an extended periods of time, and finally investing the pile at once severely limits the power of compounding. Since I sit with the majority, I’ll continue to invest my predetermined percentage into the market each month as I’m paid. But you know, even if I were to receive a large windfall from Uncle Herbert, I’m not sure my gut could handle the stress of throwing it all in at once, regardless of what the statistics say.
What about you? If you were given the above scenario in real life, knowing what you know now, which strategy would you choose?