Welcome to the fifth part of our beginner's guide to investing! By now, you should know why you should invest, how to start, the risks involved and basic returns in investing. Do check out the previous parts if you haven't already!
In this part, we will be looking at investment strategies, what they are and why you should stick to one. We will also compare two popular investing strategies, the dollar cost average strategy and the lump sum strategy. We will examine the pros and cons of each strategy, as well as determine which strategy to take. Let's begin!
What is an investment strategy?
An investment strategy is basically how you choose to invest your money. Should you put a large sum of your money in at one go, or spread it out over several months?
In the previous part of this guide, we've actually already examined two investment strategies - value investing and growth investing. A quick recap:
- Value investing
Focuses on the preservation of capital by investing in safe assets that pay out stable, growing dividends. A benefit is not having to sell anything you own, but still getting regular income every so often through dividends. In addition, you may also get some capital appreciation along with the dividends. However, dividends may be cut in times of financial trouble, and companies that focus on paying out dividends don't focus much on growth, resulting in less capital gain theoretically.
- Growth investing
A more aggressive and risky method for wealth multiplication. This strategy focuses on investing in assets that focus on capital appreciation. This means that companies usually don't pay out much dividends if any, choosing to reinvest profits into growing and expanding the company. Therefore, there may be higher capital gains over the years than value investing. However, a drawback is that you have to sell to get your profits, meaning that you usually wouldn't sell until retirement to get the most out of your profits by giving it time to grow.
Those were two investment strategies discussed previously. You can even choose to mix both of them to get the dividend-growth strategy. In the previous part, we also discussed which you would choose - depending on your risk appetite and your liquidity needs. Do check it out for a refresher if needed.
Why have an investment strategy?
Now, let us look at why it is important to have an investment strategy. We have talked a lot about risks in the previous parts of this guide. Risks in investing are very real, and can hurt badly, especially when you see the markets drop. After all, that is your hard earned money that is disappearing!
Investment strategies exist to keep your head cool in such situations. By sticking to an investment strategy, we allow ourselves to have a plan that we can follow. No matter what happens, as long as we stick to our plan, we would hopefully come out with profits. Basically, an investment strategy is just a plan of investing your money to ensure that it matches your investment needs - whether it is to grow your wealth or to preserve your wealth.
An investment strategy is also important to have because it helps in re-balancing your portfolio to diversify risks. By controlling how much money you put into the market and when you do so, you spread out your risks by time and amount. In this way, you ensure that you have sufficient liquidity in your day to day life, while also consistently putting money in the market to work for you.
In essence, investment strategies help you to control your investments in a more structured manner, letting you plan your investment direction and goal as well as manage risks along the way.
The two investment strategies mentioned above - growth and value, are investment strategies focused on the "goals" of investing - whether it be capital appreciation or capital preservation and steady income. Now, let us look at two investment strategies or lump sum investing and dollar cost averaging.
These two investment strategies, unlike the aforementioned growth and value ones, are focused on timing the amounts of money you put into the market to minimize risks involved in market timing. This ensures that if you buy in at a wrong time, you don't lose too much, while also ensuring that you continue to invest a steady amount into the market continuously to take advantage of continued growth.
What is lump sum investing?
The strategy of lump sum investing is simple. Essentially, lump sum investing is investing a large sum of money in one go. If you have $10,000 now, just put the whole thing into the market!
The idea here is to invest infrequently, but in larger sums (usually all your spare cash that you can afford to invest with). The main benefits of such an investment strategy is as follows:
- Lesser commissions
Brokers often charge commissions on trades. By investing a larger sum at one go, we minimize these commissions by reducing the percentage amounts of fees in one trade. For example, if a broker charges a minimum of $4 per trade, if we trade $1,000 at one go, that's a 0.4% commission. If we choose to accumulate to $3,000 before we do the trade, that would be a 0.13% commission!
As we can see, if we trade in too small amounts, the commissions start to become larger percentages, cutting into your overall returns. Lump sum investing helps to reduce those fee percentages. We can further reduce our commission fees by picking the right broker.
- More money in the market
Since you're putting most, if not all your spare cash in the market at one go, you are ensuring that your money stays in the market for a longer time. Rather than parking it in a savings account, you are getting increased returns from the market (hopefully). Essentially, you give your money more time to grow and outpace inflation.
- A regular plan
Give your emotions a miss when trying to time the market. Having a regular plan helps you to invest no matter what, allowing you to put money into the market with reduced analysis paralysis (basically when you think too much about when to put money into the market that you end up not putting money in at all).
Of course, lump sum investing does come with some cons as well. The main drawbacks are:
- All in or nothing
If we want to take advantage of the reduced commission percentages due to lump sum investing, we will be required to invest the whole sum into a singular trade. This can be scary especially if it appears that there are no good investment products around right now, which leads us back to the analysis paralysis syndrome mentioned earlier.
A key quality of the lump sum investment strategy is to stick to your investment plan no matter what as this avoids timing the market, but this can be a flaw as well. If you invest right before a recession, well, since you just spent an accumulated sum of money, you probably don't have much spare investment cash left. This can cause you to miss out opportunities in the next few months as you build up another lump sum.
- Higher risk
Similar to the previous point, lump sum investing is more risky since you are betting on a large sum of money at one go. If the markets turn for the worse, you are extremely vulnerable to short term volatility, and your large sum of money might drop in value quickly, which can cause the more emotional investors to panic and sell at a loss.
The main idea of lump sum investing is to play the long term game. If we buy and hold over a long time using lump sum investing, the returns we get should be stable assuming that the markets grow over a long term period. Despite the potential for short term missed opportunities and volatility, lump sum investing allows us to take advantage of long term growth due to having a majority of our available cash in the market at all times.
This gives our cash the time to grow and outpace inflation, discussed in part 1 of this guide. Of course, this also brings about a higher amount of risk, since we are putting all our cash in at one go and are thus vulnerable to short term volatility in the market. Lump sum investing may not be suitable for emotional investors.
What is dollar cost averaging?
Dollar cost averaging is the opposite of lump sum investing. Suppose we have $10,000 to invest. Instead of putting it all into the market at one go, we hold back, and instead put in say, $2,000 every month without fail.
The idea here is to spread out our investments over time, giving us some benefits:
- Avoid timing the market
Unlike lump sum investing, dollar cost averaging allows us to avoid timing the market since we put in small amounts of our spare cash quite frequently. Therefore, if the market is bearish (going down) we don't lose that much money since we only put in a bit. Similarly, if the market is bullish (going up), we still get to enjoy that rise. This lowers our risk of market volatility significantly, and thus many investors who are risk adverse prefer to dollar cost average.
- Regular plan with reduced paralysis
A benefit of dollar cost averaging, similar to lump sum investing is that it gives you a regular plan to stick to. In the case of doing dollar cost average, it is even better in the sense that since you're putting in only a small portion of your spare cash, your analysis paralysis is reduced.
If there are no good stocks to buy now because everything is overpriced, you can decide to put in a smaller amount of cash, and when things get more attractive, you can put in larger amounts of cash over time. You get to decide the frequency and amount that you invest, compared to lump sum investing where you dump all your cash in at once to take advantage of lower fees and having more money in the market immediately.
Likewise, dollar cost averaging does come with a main drawback:
- Inflation chip
A main problem with dollar cost averaging is that your money is being chipped away due to inflation. Since we are investing only part of the cash we have at regular intervals, this has the side effect of causing us to keep a lot of spare cash lying around. Sure, we could put this cash into a high yield savings account, but how high do the yields really get? You'd be hard pressed to find one with yields higher than inflation without having to have tons of credit card spend. As a result, you will usually be losing value on this sum of money that you're accumulating since it's not in the market, as compared to lump sum investing where you put it all in at once.
With dollar cost averaging, the aim is to reduce market volatility risk by entering the market at set time intervals with small amounts of money. In this way, you will reduce losses while also getting some gains along the way.
Lump sum vs dollar cost averaging
So, which investment strategy should you choose? Like many other things in investing, it depends mainly on your risk appetite and your financial state. For example, if you are afraid of risk and want to be less affected by market volatility, you will want to dollar cost average.
On the contrary, if you are willing to bear a bit more risk for greater gains, you will want to do lump sum investing, where you put in your available cash into a few securities at one go. This ensures that you have your money in the market, giving you more returns than if that money sat around in a savings account.
Note that when we say lump sum, we are basing it off a definition whereby you're putting a significant portion of your spare cash in at one go. This means that if you save $1,000 a month from your salary and invest that $1,000 every month, you're actually doing lump sum investing! A dollar cost average strategy would be to only invest $500 of that $1,000 in the first of the month, and maybe another $500 in the second half of the month, spreading out the risk of market volatility.
According to a study by Vanguard, one of the world's largest investment companies, lump sum investing actually outperformed dollar cost averaging on average (in this case, dollar cost averaging is termed as systemic investing).
As we can see, lump sum investing generally outperformed dollar cost averaging almost 70% of the time. This can be naturally attributed to lump sum investing having more money put into the market than dollar cost averaging. Since the market goes more more often than it goes down (luckily), having more money inside from the get go means that on average, money inside grows more than the money outside of the market.
From statistics, it can be seen that perhaps lump sum investing is better than dollar cost averaging. For most cases, that is true, as shown above. However, as human investors, we have to take our own emotions and peace of mind in the equation.
Who can say that they will be totally unaffected if we see the market drop? The perks of dollar cost averaging is that we won't be hit as hard if we see the markets making a turn for the worst since we still have money to capitalize on this drop. In addition, since we only put in a portion of our money, our losses aren't that hard to bear either.
For investors with a lower risk appetite, dollar cost averaging can be very attractive compared to the relatively higher risk of lump sum investing. While theoretically, lump sum gives higher returns, individual sentiments may vary depending on many factors like your investment amount and time period of investment.
In fact, one can consider a combination of the two investment strategies. Do frequent lump sum investing, but set aside a small cash pile that slowly builds up to capitalize on any opportunities.
A possible method of going about this is to stick to lump sum investing regularly, and try not to be affected by market volatility. Thereafter, if you do research on the market and feel like the market will not be doing well, or if you feel afraid that the markets will turn bearish, you can start changing to dollar cost averaging instead to build up your cash reserves to capitalize on any opportunities.
An example would be the bull run from 2008 until 2019. Since market kept going up, doing lump sum investing would ensure you get the highest returns since a majority of your money would be growing with the market. However, towards 2018-2019, there were many investors clamoring about a heavily overpriced market and that the market will crash soon.
Well, no one knows when that will happen - after all, in 2019, the market experienced one of the highest growths ever. However, if you are affected by these negative sentiments and feel iffy about investing large amounts in case the market turns bearish, then you would switch to dollar cost averaging to wait it out.
If you did so then, you might have caught the freak anomaly of the coronavirus dip, and bought some stocks at good prices due to your cash buildup. Additionally, since we never really know when the markets will bottom out, dollar cost averaging helps us further take our emotions out of the equation by consistently buying say, every week. In this case, even if we do not buy directly at the bottom, we ensure that we get some of those profits due to the dip as well.
When things get better and you're more optimistic about the market, you can then consider switching back to lump sum investing.
In this part of the beginner's guide to investing, we explored various investment strategies like growth, value, lump sum and dollar cost averaging. These strategies are just means to an end - and that end depends on what you are trying to achieve with your portfolio.
Are you trying to build, or preserve wealth? Are you risk taking, or risk adverse? These questions will help you to choose one or more investment strategies to follow, helping you invest stably and continue taking in profits by putting your money into the market.
Don't be afraid to switch up your investment strategies. Just remember that it switches up your portfolio allocation as well. If you dollar cost average, you might find yourself with more cash in your portfolio, which could be what you want... or not.
In part 2, we learnt to balance out your allocations to diversify and minimize risk. Therefore, always look at your portfolio allocations and re-balance accordingly by buying different asset types if needed - no matter your investment strategy.
Now that we've covered the basics of investing, we have to answer a burning question - which stock should we buy? Read more in the 6th part of this beginner's guide to investing!
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