Let’s say you have a large windfall of money, like $100,000, that you want to invest in stocks and bonds. There are two schools of thought on what you should do: Either invest it all at once — or slowly deploy the funds over time, tiptoeing into the market just in case a downturn is around the corner.
On one hand, if you throw the entire lump sump into the market all at once, it will have the longest time to benefit from compound growth. On the other hand, if your stocks tank shortly after you buy them, you may be riddled with regret.
So which is the best course of action? It depends on your circumstances, financial advisors say.
[See: 7 of the Best Stocks to Buy for 2018.]
When it pays to go all in. Research shows that most of the time, a lump-sum investment will outperform the alternative, dollar-cost averaging method, purely from a mathematical perspective.
Vanguard’s researchers crunched the numbers using historical returns and a hypothetical portfolio consisting of 60 percent stocks and 40 percent bonds, and they found that in the U.S., U.K. and Australia, the same conclusion held true: An immediate investment usually outperformed a systematic one.
There were only a few short-term periods in history when that wasn’t the case, and no surprise here — it was during the deepest 12-month downturns.
Most of the time, the market trends higher, and when it does, the lump sum method generates returns that on average, are 2.39 percent higher than a systematic approach that rolled out the same investment over a series of 12 months.
“I usually recommend that clients invest in a lump sum instead of dollar cost averaging,” says Ryan Bayonnet, a financial advisor with Hyland Financial Planning in Uniontown, Ohio. “Stock markets typically trend in a upward manner, so in most cases, if you leave cash sitting on the sideline as you wait to contribute via dollar cost averaging, markets will appreciate before you can invest. That means that you will be buying in at a higher cost, and realizing lower investment returns.”
When it may be better to tiptoe. Of course, there’s an emotional component to investing, too. Humans don’t always behave rationally. Although the math shows the odds are in your favor if you dive right in, not all investors are comfortable taking on that kind of risk.
[See: 11 Steps to Make a Million With Your 401(k).]
Behavioral psychologists have well documented that for most people, losses hurt more than gains feel good, and as a result, many investors are prone to making rash decisions in a downturn.
Think about how you might react if you invested your $100,000 and the next day, it plunged 10 percent. How would you react? Would you leave the money in the market? Or withdraw it almost immediately? If you’re a risk-averse person and prone to anxiety, dollar cost averaging may be the best way to go, simply because it protects you from emotional risk.
“If I have a pile of cash, the best thing to do academically is to invest the lump,” says Mark Wilson, president of MILE Wealth Management in Irvine, California. “Behaviorally, I prefer to invest the cash over time to protect against the bad-case scenario.”
It’s a stressful decision and yes — trickling the investment may not earn as high of a return as the lump sum approach, Wilson admits — but if it helps you cope with the stress of investing in the first place, it may be worth it.
In reality, most Americans are not sitting on large piles of cash, and the slow and steady method of saving, like through a 401(k) account, is simply the default way to invest. Automatic salary deferrals make the process gradual and can eliminate impulse-driven decisions.
Assess yourself. But if you do find yourself lucky enough to deal with a large lump sum — say from an inheritance, a rollover, the sale of a business, a large tax refund or lottery winnings — consider your own tendencies, says Bobbie Munroe, a senior planner with Supporting Your Choices in Havana, Florida.
Have you already been investing for a long time, and have you built up a track record of accepting risks and remaining calm in downturns? If so, then go all in with the lump sum.
[See: 13 Ways to Take the Emotions Out of Investing.]
If you’re a new investor, or have panicked at prior downturns, you may want to tiptoe in with the trickle method, first.
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The Best Ways to Invest a Lump Sum of Cash originally appeared on usnews.com
