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| Sequence of Return Risk: Lump Sum Investment vs. Dollar-Cost Averaging |
Investing is a critical decision that requires a lot of considerations. Investors face numerous challenges, one of which is the sequence of return risk. This article aims to provide a deeper understanding of this risk, as well as explore the relationship between the two most common investment methods, lump sum investment and dollar-cost averaging, in overcoming the said risk. The article also employs the Monte Carlo simulation to compare the final returns obtained from each investment method.
The Reason for Sequence Risk - Market Fluctuations
The sequence of return risk stems from market fluctuations. Stocks do not experience constant growth; they fluctuate, sometimes rising and sometimes falling. This fluctuation creates volatility in stock prices, which is considered a risk. In a market trend that always rises, a lump sum investment is an excellent option since it will have more assets due to its lower costs. The higher average cost of installment purchases will result in fewer shares and, thus, fewer assets. However, the real market environment is not always rising, making stock prices prone to volatility.
Market Fluctuations Create Volatility in Stock Prices
The volatility of stock prices, mathematically defined as standard deviation, determines the risk. The greater the value, the higher the volatility of stock prices. Conversely, the smaller the value, the lower the volatility. Thus, when evaluating long-term market trends, the stock price may seem to be rising, but the process also includes ups and downs due to volatility. In the Monte Carlo simulation, two factors simulate market trends, the annualized return rate and the annualized volatility.
Lump Sum Investment or Dollar-Cost Averaging in a Long-Term Bull Market with Fluctuations?
The Monte Carlo simulation aims to simulate the investment process that investors may experience in a fluctuating market. It is more realistic than the previous single linear (non-fluctuating) one, but it cannot predict the future. Therefore, in the following simulation test, we assume a 30-year investment period, with continuous investment without interruption. As annualized return rates and annualized standard deviations can be combined into numerous combinations, this article uses a 5% annualized return rate and a 10% annualized standard deviation to provide a reference. It explores the range of returns and the volatility of returns between lump sum investment and dollar cost averaging.
Monte Carlo Simulation: Lump Sum Investment vs. Dollar Cost Averaging
Under the Monte Carlo simulation, the 5% annualized return rate and 10% annualized standard deviation are used to compare the returns of both lump sum investment and dollar cost averaging.
Dollar-cost averaging:
Highest return: 833.5%
Lowest return: -37.21%
Average return: 149.09%
Return standard deviation: 173.35%
Lump sum investment:
Highest return: 2751.62%
Lowest return: -51.6%
Average return: 404.86%
Return standard deviation: 447.29%
The Monte Carlo simulation comparison indicates that in a long-term bull market with fluctuations, lump sum investment offers higher returns and greater volatility, making it an excellent option to overcome sequence risk. In contrast, dollar-cost averaging provides lower returns and lower volatility. However, it is essential to remember that investing is not a one-size-fits-all approach. Investors must consider their unique circumstances and investment goals when choosing their preferred investment method. Finally, past performance does not guarantee future results; hence, the Monte Carlo simulation should only be used as a guide and not a guarantee of future returns.
