I recently maxed out my Roth IRA for 2008. This is the first time I’ve had enough income to make the full contribution for a year. Thank you, full time job!
In fact, since I kept living like a college student after landing my job, I managed to save up quite a bit of money over the past year. Here I am at the beginning of 2009, and I already have enough saved up to max out my Roth IRA for 2009. This has never happened before, so now I have a decision to make.
Should I invest the $5,000 in my Roth IRA immediately as a lump sum or should I invest it over the course of the year by dollar cost averaging?
When I first started getting into personal finance, I remember reading about the benefits of dollar cost averaging (DCA) everywhere. DCA is basically investing a fixed amount of money at regular intervals over a defined period of time. This results in buying more shares when the price is low and fewer shares when the price are high, making your average cost per share lower over time. This sounds great, and I’ve read it so many times that I assumed DCA would be the way to go.
Well, I was wrong.
After doing some research, it turns out DCA almost always produces lower returns compared to lump sum investing in diversified portfolios over long periods. The only time DCA is effective is when the market is going down, and over time the market rises more than it falls. By investing the lump sum immediately, your money has more time to work for you in the market.
From the information I’ve found, it looks like investing the money as a lump sum is the best approach to maximizing your returns in the long run, so that’s what I’m going to do. What would you do if you were in my shoes?
Here are some other opinions on the topic of dollar cost averaging versus lump sum investing.
- The Costly Myth of Dollar Cost Averaging at MSN Money
- Does Dollar Cost Averaging Work? at Moolanomy
- You’ve Got Money: Invest It All or Dollar Cost Average? at The Digerati Life
- Dollar Cost Averaging versus Lump Sum Investing at My Money Blog
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You have a self directed IRA right? I would put it all in at once, but don’t necessarily invest it in the stock market yet. Personally I would hold it until you hear mainly good news about the economy. Until then I would keep it in a money market fund in your IRA.
I got lucky and got out at the beginning of last year before the market headed south. My money has been in a money market fund all last year!
I think it’s probably a good time to invest a lump sum. Even though DCA produces lower returns, it also mitigates a level of risk. If you put that 5k in over a period of 12 months, you are taking on lower risk. I assume your time horizon is still pretty long, though, since this blog has the word “student” in it. I think that offers some comfort to you if you’re thinking of making a lump sum investment. Of course, if the Dow is at 5k in 3 months, you’ll wish you were DCA. That’s the benefit of it. You can take ever so slightly lower returns and not worry that you invested your money at a peak, and you can feel good when the market dips – because it means more shares next month.
Well last year, I put in most of the money at the beginning of the year (January/February timeframe) since I had a lot of overtime from working over Christmas and New Year’s Eve/Day. Dollar cost averaging would have been a much better choice.
This year I’ll have to average it because I won’t be making that much money. I’ll still try to max it out as soon as possible, though, because I hate keeping track of deposits & investments in several different places at once.
Congratulation on being able to max out 2009 IRA already. I still have another $2,500 to contribute for 2008, so I am definitely behind. But this what happens when you try to max out 401k and has IRAs for two person.
If you have the money now, I think you should add it all in. DCA works in down and/or volatile market which we are in now. However, market timing doesn’t work in the long run and in the long run the trend is for the market to go up so DCA doesn’t work most of the time.
The bottom line here is that under most conditions, getting your money into the market as soon as possible is the best way to go. If I had $5000 to invest today, I would do so. If I only had $500, I would invest that too, and then invest another $500 next month, etc. There’s no point to stretching out a $5000 investment over time.
The other advantage to investing in lump sum appears if you intend to invest your Roth IRA money in individual stocks or ETFs. Most discount brokerages offer free mutual fund trades and while you pay a fee for stock/ETF purchases (except Zecco which has the reverse model). If you DCA while still investing in stocks/ETF at a typical discount brokerage you wind up paying a good chunk of money in fees over the course of a year. Conversely, if you invest that money in a lump sum you minimize the fees for the stock/ETF investments.
I’d have to agree with you. I’ve got a Roth IRA too and I basically do my investment research, put all money it at once and buy my investment products.
Dollar cost averaging doesn’t seem useful when some of the mutual funds I buy have a $1000 minimum purchase prices. To use DCA I’d need to keep reinvesting in the funds and stock I already have and wouldn’t be able to diversify.
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