Is Dollar Cost Averaging the Right Strategy for You?

You've just received a bonus or an inheritance, and you know that investing your money in stocks and bonds is one of the best ways to create long-term wealth. But you're also worried that your investments might lose value instead of gaining it.

It's a common struggle: You want the financial rewards that can come with investing, but the potential risk of losing money nags at you. (See also: How to Get Over These 5 Scary Things About Investing)

An investing strategy known as dollar cost averaging might be the answer.

What is dollar cost averaging?

In dollar cost averaging, you invest just a small chunk of money at a time. This differs from the more traditional approach to investing, in which you'd invest all the money that you've targeted for stocks, bonds, or real estate at the same time.

Say you've inherited $6,000. You'd like to invest that money in the stock market so that it will grow over time. If you were investing in the traditional way, you'd invest that money all at once. With dollar cost averaging, though, you would invest more gradually, perhaps investing $500 each month throughout the course of a year. That way, you'd buy more stocks when prices are low, and fewer stocks when they're high. (See also: 9 Investing Questions You're Too Embarrassed to Ask)

The main benefit of dollar cost averaging is that it reduces your financial risk. Say you invested all that money in stocks at once. A market crash three months later would then impact all your money. But if you'd just invested, say, $1,500 before the market crashed, you'd still have $4,500 of your original $6,000 left untouched by the financial turbulence.

Paycheck contributions versus lump sum investing

If you contribute the same amount to your 401(k) every paycheck, that's equivalent to dollar cost averaging. By default, most people have the same amount deducted from their paycheck each month, so there is no choice to make. Dollar cost averaging, however, usually refers to a choice the investor makes when they've got a lump sum of money, such as an inheritance, royalty check, or bonus. If you don't have a windfall of some sort, you usually don't have to worry about whether or not to do dollar cost averaging.

Pros and cons

The main advantage of dollar cost averaging is the reduced risk of losing as much money in a market downturn. But there's another advantage, too: Dollar cost averaging makes it easier for reluctant investors to enter the market.

If you're hesitant about investing, you might find it easier to take the jump if you are investing a smaller amount of money. And that's a good thing: Over time, the stock market has tended to increase in value. If you don't invest, you won't get the chance to take advantage of this.

Anything that encourages you to invest — such as dollar cost averaging — is a positive.

There is a drawback, though, to this approach: By limiting your risk, you are also limiting the potential size of your financial rewards.

Because the stock market has historically increased in value over time, the odds are that you'll make more money if you invest a larger sum all at once. The sooner you invest the money, the more time it has to grow. By contrast, if you invest smaller bits of money over time, you will tend to see smaller returns in what has historically been an upward-trending market.

A recent study by Vanguard illustrates this. Vanguard studied whether people would see higher returns by investing a large sum of cash all at once or in smaller doses over a six-month period into a portfolio of 60 percent stocks and 40 percent bonds. They found that investing the lump sum of cash all at once produced higher returns about two-thirds of the time. The longer the investment period, the higher the chance that the lump sum investment would outperform the dollar cost averaging strategy. (See also: The Basics of Asset Allocation)

You'll have to decide whether the reduced risk outweighs the potential of losing out on bigger returns.

Of course, it's most important that you do invest your money over the long term. And if dollar cost averaging, and the reduced risk that comes with it, is what encourages you to do this, then it might be the best approach for you.

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