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For many investors a windfall can financially turn their lives around. But investing that money wisely can be a daunting prospect – there are almost too many questions to answer.
The theory of dollar-cost averaging can help relieve some of those fears. But is using money to regularly invest over a longer period of time really safer than investing in a lump sum?
Dollar cost averaging refers to a financial practice in which investors continually buy shares both when the market is doing well, and poorly, in order to provide better returns over a longer period without the risk of losing a large sum of money. According to the theory, the average cost of the shares will actually go down over time, even though the actual price may fluctuate from year to year.
However, investors should take note that dollar cost averaging is not the same as another, similar strategy of automatically buying shares or other investments on a regular basis over long periods of time. Instead, dollar-cost averaging refers to the decision made to invest a specific amount – say, a windfall received through an inheritance – over time, rather than all at once.
There are conflicting takes on the effectiveness of dollar-cost averaging. A 2012 report from Vanguard found that an amount of $1 million invested as a lump sum would outperform a dollar-cost averaging strategy in the Australian market over a period of 10 years by 1.3% (Assuming a portfolio of 60% stocks to 40% bonds.)
However, this doesn’t mean a dollar-cost averaging strategy should be done away with altogether. For many investors, particularly those investors who already have a mortgage and are paying down debts, reducing the amount of risk in an investment strategy can make a dollar cost-averaging strategy worthwhile.
Even though the returns may not match the market, there is peace of mind in knowing that should the market take a downward turn, not all of the money will be lost.
However, a falling market can actually help investors using a dollar cost-averaging strategy. Research from various financial bodies show dollar cost-averaging to perform better during market downturns, as the regular purchase of shares or other investments translates to a larger gain during a recovery.
Whether investors use a dollar cost averaging strategy or prefer to invest a lump sum, it’s important to remember that building wealth is done over the long-term. Those who have the vision to see through market ups and downs are on their way to achieving significant returns.
Disclaimer: The information on this site is of a general nature only. This is not a recommendation or endorsement of any product or investment. It does not take your specific needs or circumstances into consideration. You should look at your own personal situation and requirements before making any financial decisions or consult the advice of an accountant or financial adviser.