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Based on empirical data, lump sum investing is often the better approach over the long run.

So why do I like dollar cost averaging (DCA)?

There are a few reasons.

The first is that it is great for small investors. 

DCA is Tailor-Made for Small Investors

While I believe DCA is beneficial for any size investor, it is tailor-made for small investors.

The majority of investors are what I would consider small in nature. They do not have thousands of dollars just sitting around ready to invest in lump sums should a buying opportunity arise.

So they have two choices.

One, stockpile cash reserves until they reach a critical mass, then buy in lump sum.

As I have written before, always store cash reserves in highly liquid assets that offer a positive return. These include: money market funds, sweep accounts through your broker, short-term Guaranteed Investment Certificates or Term Deposits through your bank.

Two, purchase investments slowly and consistently over time. Using DCA, or other averaging methods, until reaching the desired quantity.

While studies show that buying in lump sum initially is the better long-term strategy about 66% of the time, that reflects buying up front. If you need to accumulate cash over time before investing, I think the results will differ.

Longer the Delay, the Less Advantage for Lump Sum

The longer the accumulation period needed, the greater the potential variance. For someone without ready investment cash for an initial lump sum purchase, I think DCA may not underperform over time. That is, DCA is the better system.

For example, let us revisit a previous example which showed lump sum a superior approach.

You wish to invest $20,000 in Intel under either a lump sum or DCA method. Commissions are $10 per transaction. DCA will accumulate shares quarterly during the year. Share price during the year is: January 1, $19.99; April 1, $24.95; July 1, $33.27; October 1, $49.99; December 31, $50.00.

In our previous example, we assumed the lump sum investment was made January 1. You purchase 1000 shares and the unrealized gain at December 31 was $30,000.

Under DCA with quarterly purchases beginning January 1, you end up with 700 shares and an unrealized gain at December 31 of only $15,000.

A clear win for lump sum investing.

But say you do not have $20,000 to invest on January 1. It may take 6, 9, or 12 months to amass that amount. But you wait as you prefer the lump sum approach.

Ignoring rounding and interest income as you save the cash, if you bought at July 1, you would get 600 shares for your $20,000. If you wait 9 or 12 months, you are able to buy 400 shares. At year end, your unrealized gains are $10,000 for the July 1 purchase and $0 for the October 1 or December 31 acquisitions.

With a total unrealized gain of $10,000, you fall short of the $15,000 gain under DCA.

Depending on the price change of the asset being acquired and the delay in making the lump sum purchase, DCA may have a much better outcome in performance than with lump sum.

Summary

So while empirically an initial lump sum purchase may often outperform DCA in the long run, I do not take those findings as gospel.

First, the studies indicate that lump sum investing is superior about 66% of the time, in the very long run. That is not a slam-dunk.

Second, while the very long run trend in asset valuations is positive, you may need to wait a very long time. And if you buy in at the wrong moment, you may never fully recover depending on your age. Remember that it took 25 years to fully rebound from the 1929 crash of the Dow Jones Industrial Average.

Third, as we have seen above, the lump sum outperformance assumes an up-front investment. If you need to delay your lump sum purchase due to a lack of capital, the results may differ significantly. The longer the delay, the greater the potential variance.

So despite the empirical data, unless you have adequate cash reserves to invest lump sums initially, I believe most investors should utilize DCA.

We will look at a second reason in support of DCA next time.

How DCA promotes a disciplined and consistent approach to investing.

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