investing

The best way to invest a windfall

Highlights
  • At first glance, it may appear that a gradual schedule is safer.
  • A big risk to dollar-cost averaging is that you'll delay investing.
  • "Diversifying your assets is more important than diversifying over time."

Many people who are saving for retirement or college invest a fixed amount of money on a regular basis, such as every time they're paid. This approach, often referred to as dollar-cost averaging, reflects the fact that few investors have vast sums of money sitting around, waiting to be invested.

The question arises, however: If you do have a lump sum to invest -- perhaps you received an inheritance or have pocketed the proceeds from a home sale -- should you put your money into the market all at once? Or, are you better off investing as you normally would, and putting portions of your money into the market over time?

Reducing the chance of regret

At first glance, it may appear that a gradual schedule is safer, as you won't have to worry that stock prices will plummet the day after you plunk down a large sum. This thinking is called "loss minimization," says George Constantinides, professor of finance at the University of Chicago. You want to reduce the chance that you'll regret your actions. Because no one knows what the market will do, it might seem like you can hedge your bet by getting into it over time.

However, "this decision is not supported by any rational decision making (model)," Constantinides says. In fact, the research shows that most of the time you'll end up with more money if you invest a lump sum all at once.

Consider the work done by Gregory Singer, director of research, and Ted Mann, analyst, both with Bernstein Global Wealth Management. They calculated the results of investing in the Standard & Poor's 500 using both lump sum investing, as well as dollar-cost averaging, for all the rolling 12-month periods between 1926 and November 2008.

The average yearly return for the "lump sum" approach, or investing everything at the beginning of the year, was 12 percent. That compares with 8 percent under dollar-cost averaging. Their research appeared in the April 2009 issue of Trusts & Estates. (For periods prior to 1974, Singer and Mann used the overall return on the stock market.)

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Why doesn't dollar-cost averaging come out ahead? Singer and Mann point out that the stock market has tended to rise in value over time. That means that while some of your money is sitting out for even part of a year, you're probably losing potential gains.

An even bigger risk to dollar-cost averaging is that you'll delay, second-guess yourself and not get into the market for several years, says Charles Bennett Sachs, CFA, CFP and vice president and wealth manager with Evensky & Katz Wealth Management in Coral Gables, Fla. While you would avoid the market declines, you also would miss the upside.

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