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So you have a significant sum of money to invest. When it comes to investing a large amount, two primary strategies often come to mind: Dollar Cost Averaging (DCA) and Lump Sum Investing (LSI). Both have their pros and cons but choosing between the two can greatly impact investment outcomes.
Should I invest it all at once or spread it out over time? This question pits Lump Sum Investing against Dollar Cost Averaging. You've likely heard of each of these approaches. Most people don't directly reference Lump Sum Investing as a unique strategy, but it applies all the same. Each approach has its own advantages and drawbacks, making it crucial to understand why each approach is used and make an informed decision when dealing with your own investments.
Understanding Dollar Cost Averaging
Dollar Cost Averaging is the practice of spreading out investments over a period of time, typically by investing a fixed amount at regular intervals. This method helps to mitigate the risk of investing all your money at a market peak and can reduce the emotional stress of market volatility. For example, if you receive a $12,000 bonus, instead of investing the entire amount at once, you might invest $1,000 each month over a year.
Northwestern Mutual Study
According to a study by Northwestern Mutual, which back-tested investment returns over a 12-month period, investing a lump sum typically outperforms dollar-cost averaging. Here are some key findings from their research:
*All Equities Portfolio: The Lump Sum strategy outperformed DCA 70% of the time.
*60/40 Portfolio (60% equities, 40% bonds): The Lump Sum strategy came out on top 80% of the time.
The logic behind this is straightforward: markets tend to trend upward over time. By investing a lump sum, you allow the entire amount to benefit from market gains sooner, compared to gradually feeding money into the market and potentially missing out on initial growth. As the saying goes, "Time in the market is better than Timing the market".
That doesn't go to say Dollar Cost Averaging is necessarily a "bad" idea. We essentially are Dollar Cost Averaging every time we take money out of a paycheck for our 401k. Dollar Cost Averaging can provide confidence by reducing the impact of short-term volatility and ensuring that not all of your money is exposed to market risk at once. As opposed to the potential emotional and psychological stress of seeing a large investment drop in value in the short term.
Our Thoughts
Ultimately, the best strategy depends on your personal risk tolerance, investment goals, and emotional comfort with market volatility. If you can handle the potential short-term swings, Lump Sum investing may offer higher returns. However, if you prefer a more gradual approach that can mitigate the emotional strain of investing a large sum all at once, Dollar Cost Averaging might be the better choice for you.
Some individuals might land somewhere in the middle. If you have any questions about which strategy is best for you, contact us, we're happy to help with a complimentary consultation. Similarly, don't hesitate to reach out if you have any questions you would like us to cover in a post or newsletter. We're always looking for feedback and enjoy hearing from you, our clients.
Cheers,
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