A well-known investment technique called dollar-cost averaging encourages investors to gradually invest fixed sums of money into the market at regular periods. This causes the investor to automatically buy more shares when the market is lower, while buying fewer shares when the market is higher.
This is how most employees invest in their retirement plans: a specific amount is deducted from each paycheck and is invested into their retirement account.
However, research conducted by the Vanguard Group says that, on average, investing large lump sums of money immediately would have historically resulted in bigger portfolios two-thirds of the time.
Why did this occur? Vanguard said this is because when dollar-cost averaging a lump sum into the markets, the temporarily non-invested portion is held in cash. Over time, stocks and bonds have beaten cash, so holding some of the money out of the market results in lower portfolio returns.
Does this invalidate dollar-cost averaging? No. When investing in a retirement plan, investable cash becomes available only in relatively small amounts over time, which makes dollar-cost averaging a prudent way to invest.
Additionally, lump-sum investing works best only when the investor can maintain emotional patience in spite of market fluctuations. If a lump-sum investment is followed by an immediate market decline causing investor regret and fear, the investor may discard their original investment plan. In this case, it would probably be better to dollar-cost average the money to keep the investor comfortable with staying the course.
Let me remind you that investment success is dependent in large part on your behavior as an investor. To the extent that an investor believes the upward trend in markets is likely to exist in the future, lump-sum investing would remain the preferred method for investing. But if the investor is primarily concerned with reducing short-term downside risk and regret, then dollar-cost averaging is the better alternative.
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