New Year! Let’s talk about investing. You’re thinking about maxing out your IRA for the year right now. You’re going to have a fresh new $5500 contribution to your account to use for tax-free/deferred investing. Is it better to invest this lump sum or should you be dollar cost averaging?
There’s been recent studies about comparing dollar cost averaging over time versus investing a lump sum amount one time. The IRA is a great place to perform this study since it can cover both dollar cost averaging and lump sum scenarios:
- Scenario A: You make enough earned income to contribute $5500 the first month of the year, thus investing a lump sum
- Scenario B: It takes you a few months to work and make enough to fully contribute the $5500 into your IRA, thus investing by dollar cost averaging
Is dollar cost averaging better than lump sum investing? It’s nearly impossible to time the market correctly. If everyone knew when to buy and when to sell, the whole world of investing would break out into anarchy.
I’ve put together a spreadsheet to analyze the effects of dollar cost averaging over the the past 10 years to see how well or how bad you would’ve done. In this experiment, I am using $6000 per year instead of $5500 since we’re just analyzing two strategies.
Time Frame: January 2004 – December 2014 — This included the crest of the last bubble and the trough of the housing market crash. We will see how well dollar cost averaging survived through the best of times and the worst of times.
Dollar Cost Averaging Experiment
In this scenario, we spend $500 per month buying the VTI at whatever the cost is. Assume we buy at the end of each month. Since we are including dividends, these will be added into the portfolio at the end of the month.
What if you spent $500 on VTI every month from Jan 2004 to Dec 2014?
Dollar Cost Averaging – Portfolio Growth Over 10 Years
Now let’s take a look at lump sum investing over the last 10 years…
In the Lump Sum experiment, we will look at the results of investing $6000 at the beginning of each year and seeing where that takes us.
Lump Sum Experiment
We will take $6000 and invest it into VTI in January of each year. Purchases are assumed to be at the end of the month. This is to reflect the “earned income” rule of IRAs (you can only contribute earned income into an IRA. This means you’re not legally allowed to contribute money you gained from dividends or interest, etc). All dividends gained however can and will be reinvested to maximize investments. Here is the experiment:
What happens when you take $6000 and invest it at the beginning of each year from 2004 to 2014?
Lump Sum Portfolio Growth Over 10 Years
It lies behind the practicality of it. Sure in an ideal world, we’d invest thousands of dollars once and never look back. But reality sets in and we realize we don’t have that kind of money. We have periodic expenses and periodic paychecks. With these periodic increments of cash, it makes more sense to the average investor to follow a dollar cost averaging approach. In either scenario, the investor ends up with a net positive return, which is still a winning situation.