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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’ll 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.
- For a long-term investor, it pays to put your money to work as soon as possible. With the normal trend 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 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.
- 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, that is, trying to buy when the price looks especially attractive. 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 such as 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 possibly 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 may deliver a minimal return. If current interest rates on low-risk cash accounts are close to zero, then your opportunity cost is low. If rates are higher, however, then investing a lump sum may be less attractive since you could otherwise earn cash on your uninvested balance.
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. You may need to rebalance your investments over time to keep them in line with your target allocations. 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 via dollar-cost averaging and 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, without having to sell a large position and potentially realizing a capital gain.
If you have a concentrated position in a stock, perhaps due to receiving stock-based compensation from your employer, the lump sum can be used to invest in other types of investments to offset the impact of the concentrated position.
It’s easy to get caught up in an issue such as 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.
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.