You may have heard of the terms “systematic investing” and “dollar cost averaging,” but not know what they mean or what’s the difference. Without realizing it, you are likely applying both if you are contributing to an employer retirement plan or have an automatic investment program set up.
Systematic investing
With systematic investing, you contribute automatically on a repeated basis (typically weekly or monthly) a set sum or percentage to an investment, such as a mutual fund, or employer retirement plan. Contributions may come from your checking account for an investment or your paycheck for an employer retirement plan. The contributions normally stay on a steady schedule — weekly or monthly, — until you cancel it.
Systematic vs. lump sum investing
Are you better off applying systematic investing or making a lump sum investment, that is, invest all at once? You may be able to make a lump sum investment at a low price and then sell at a higher price, but you are taking the risk of timing the market.
Lump sum investing – that is, fully investing from day 1, can be intimidating because you cannot know if your timing will be favorable or unfavorable. Dollar cost averaging can ensure that you are buying in at different prices over different timeframes. This does happen at the expense of not fully investing, so you will not be exposed to the full amount of gains or losses as you would otherwise be in a lump sum investment. There are benefits and disadvantages to each strategy. Finding the investment philosophy you believe in and will follow through on is what is most important.
Dollar cost averaging.
With dollar cost averaging, you’re investing the same dollar amount on a regular, periodic basis, regardless of the share price of the investment. When the price drops, you will be buying more shares for the same dollar amount. And when the market goes up, you will buy fewer shares.
Scenarios*
Let’s take a look at how lump sum investing and dollar cost averaging fared during two different time periods with an S&P 500 Exchange-Traded Fund (SPY), which tries to mirror the performance of the S&P 500 Index.
The Great Recession.
Just before the Great Recession was going to unfold, if you started on Nov. 1, 2007 making monthly investments of $1,000 for one year, you would have lost $2,927.84. But had you made a lump sum investment of $12,000 on Nov. 1, 2007, one year later your loss would have been higher at $4,017.34.
The Pandemic.
If, however, you had made a lump sum investment of $13,000 near the beginning of the pandemic (3/23/20), you would have a $10,260.54 increase in value. If you had invested $1,000 monthly for 13 months for the same time period, you’d have a $2,802.92 increase – much less than the lump sum investing.
So, when all is said and done, does systematic investing and dollar cost averaging make sense for you? Dollar-cost averaging takes the emotion out of investing, thereby ensuring that a person invests consistently, because a person cannot tell when the worst days or the best days of the market will happen. So if you’re looking for a disciplined approach to investing for a long-term goal and want to avoid market timing, it very well may be.
*Source: Scenarios generated by Citi Personal Wealth Management