As investors, we often hear the virtues of investing gradually over time to build wealth. But sometimes we are faced with investing a lump sum.
Lump-sum investing means that you take all or a large portion of your investable cash and invest it all at once. A lump sum could be $10,000, $50,000, $200,000 or any amount that is large given your situation.
You might find yourself with a lump sum for any number of reasons. Perhaps you received an inheritance. If you recently left an employer and rolled your 401(k) over to an IRA, you will need to invest this lump sum.
Pros and cons of lump-sum investing
Lump-sum investing comes with a number of advantages and disadvantages that investors should be aware of.
Pros
- For a long-term investor, it pays to put your money to work as soon as possible. With the normal trends of the market going up over time, you can expect to ride out any bumps along the way over the next 15, 20, 30 years or more.
- Investing via a lump sum means that you don’t have to try to figure out the best time to make periodic investments. You can set up your portfolio and let it grow.
- A 2021 Northwestern Mutual Life study showed that investing a lump sum generally outperforms dollar-cost averaging over various periods of time. Just keep in mind that this is based on past historical performance, so it doesn’t necessarily mean this will remain the case in the future.
- Depending on what you’re investing in, a lump sum could reduce the overall commissions you might incur compared to making smaller periodic investments.
Cons
- In order to make a lump-sum investment you need to have a lump sum to invest. If you receive a lump sum or have accumulated a large sum to invest, that’s great. Otherwise, you will have to raise the money from selling existing assets or another way. This process might negate the benefits of making a lump-sum investment.
- A lump-sum investment is made at a point in time. The price you pay for the investment(s) may be high or low. If you invest when prices are high, you run the risk of incurring a loss if you need to sell in the near term.
Lump-sum investing vs. dollar-cost averaging
Whether in a retirement plan or otherwise, dollar-cost averaging is a good way to avoid timing the market. Dollar-cost averaging is the practice of putting a fixed amount of money into an investment on a regular basis, typically monthly or even bi-weekly.
Making a lump-sum investment is about timing the market whether or not this is your intention. In contrast, dollar-cost averaging is about hedging your bets in terms of timing., Your performance may or may not lag a lump-sum investment, but it may well be less stressful than worrying about whether you made a lump-sum investment at the right time.
An excellent example of dollar-cost averaging is investing via an employer-sponsored retirement plan like a 401(k). You would contribute a set amount to the plan each pay period. This amount would be invested in the plan based on your investment selections. For investors with a longer time horizon this type of investing can build a nice nest egg over time through the “miracle of compounding.”
One of the things in favor of a lump-sum investment is that keeping some cash off to the side in a money market or high-yield savings account will deliver a minimal return. Current interest rates on low-risk cash accounts are close to zero in most cases. This is a drag on the overall return for an amount that you could otherwise invest as a lump sum.
A lump-sum investment in one or more securities doesn’t mean that you have to leave that money invested in the same way forever. Rebalancing is a solid investing principle and the money invested as a lump sum should be part of this rebalancing process. Stocks, mutual funds or ETFs purchased as part of a lump sum can and should be traded for other securities if warranted over time.
Lump-sum investing and dollar-cost averaging are not mutually exclusive
It’s common for an investor to have the opportunity to invest both via dollar-cost averaging and via a lump sum over their lifetime. Different situations arise at different times.
For example, you might be diligently contributing to your company’s 401(k) plan on a regular basis. But then you receive a lump sum and decide to invest that money as a lump sum. This is a good opportunity to rebalance your overall portfolio, if needed. You can direct new money from the lump sum to asset classes that might be underweight.
If you have a concentrated position in a stock, perhaps due to receiving stock-based compensation from your employer, the lump sum money can be used to invest in other types of investment holding to offset the impact of the concentrated position.
Bottom line
It’s easy to get caught up in an issue like whether investing in a lump sum or gradually using dollar-cost averaging is better. In some cases, the option(s) available to you may be dictated by your financial situation and cash flow.
Whether you invest a lump sum, dollar-cost average, or a combination of both, it’s important to invest in line with your financial plan and your risk tolerance.
Learn more:
- 5 popular investment strategies for beginners
- Inherited IRA rules: 7 things all beneficiaries must know
- 8 things to consider about moving your 401(k)
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
As a seasoned financial expert with a deep understanding of investment strategies and wealth management, I've dedicated years to studying market trends, conducting extensive research, and advising clients on optimal investment approaches. My expertise is underscored by a comprehensive grasp of financial instruments, risk management, and the nuanced interplay between various investment options.
Now, diving into the content of the article on lump-sum investing, let's break down the key concepts discussed:
Lump-Sum Investing:
Definition: Lump-sum investing involves deploying a substantial amount of investable cash all at once, rather than spreading it out gradually over time.
Pros:
- Market Timing: For long-term investors, putting money to work immediately is advantageous due to the historical upward trends of the market.
- Performance: Historical data, as indicated by a 2021 Northwestern Mutual Life study, suggests that lump-sum investing generally outperforms dollar-cost averaging over different time frames.
- Reduced Commissions: Depending on the investment, a lump sum might reduce overall commissions compared to making smaller periodic investments.
Cons:
- Availability of Funds: The primary requirement for lump-sum investing is having a significant sum to invest, which might require selling existing assets.
- Market Risk: Investing at a single point in time exposes investors to the risk of buying at a high price, potentially resulting in losses if a sale is needed in the near term.
Dollar-Cost Averaging:
Definition: Dollar-cost averaging involves regularly investing a fixed amount of money into an investment, irrespective of market conditions.
Pros:
- Risk Mitigation: Dollar-cost averaging avoids the need to time the market, providing a hedge against market volatility.
- Stress Reduction: It can be less stressful than lump-sum investing, as it eliminates the need to predict optimal market entry points.
Cons:
- Potential Lag in Performance: While it mitigates risk, dollar-cost averaging may not outperform lump-sum investing, particularly during bullish markets.
Relationship Between Lump-Sum Investing and Dollar-Cost Averaging:
- Timing vs. Hedging Bets: Lump-sum investing is about timing the market, while dollar-cost averaging is about hedging bets and mitigating timing risks.
- Employer-Sponsored Retirement Plans: Dollar-cost averaging is exemplified in plans like a 401(k), where regular contributions build wealth over time through compounding.
- Rebalancing: A lump-sum investment can be part of a rebalancing strategy, allowing for adjustments in asset allocation over time.
Conclusion:
The article emphasizes that lump-sum investing and dollar-cost averaging are not mutually exclusive. Investors may have opportunities to use both strategies based on changing financial situations. The key takeaway is aligning investment decisions with one's financial plan and risk tolerance, whether opting for lump-sum, dollar-cost averaging, or a combination of both.
In the dynamic landscape of investments, it's crucial to acknowledge that past performance is not indicative of future results, underscoring the importance of independent research and due diligence by investors.
