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As investors, we often hear the benefits of investing gradually to build wealth. But sometimes we are faced with investing a lump sum.
Lump sum investing means that you invest (a large part of) your investable cash in one go. A lump sum can be €10,000, €50,000, €200,000 or another amount that is large given your situation.
You may receive a fixed amount for various reasons. Perhaps you have received an inheritance. If you recently left an employer and rolled over your 401(k) to an IRA, you will need to invest this lump sum.
Advantages and disadvantages of lump sum investing
Lump sum investing comes with a number of pros and cons that investors should be aware of.
Positives
- For a long-term investor, it pays to put your money to work as quickly as possible. With the normal trend of the market rising over time, you can expect to ride out any bumps over the next 15, 20, 30 years or more.
- Investing a lump sum means that you do not have to look for the best time to invest periodically. You can set up and grow your portfolio.
- A 2023 Northwestern Mutual Life Study showed that lump sum investing tends to outperform dollar-cost averaging over several time periods. Please note that this is based on past historical performance and does not necessarily mean that this will continue to be the case in the future.
- Depending on what you invest in, a lump sum can reduce the total commission you may incur compared to smaller periodic investments.
Cons
- To make a lump sum investment, you must have a lump sum of money to invest. If you get a lump sum or have a large amount built up to invest, that’s great. Otherwise, you will have to raise the money by selling existing assets or in some other way. This process could negate the benefits of a lump sum investment.
- A lump sum investment is made at some point. The price you pay for the investment(s) can be high or low. If you invest when prices are high, you risk making a loss if you have to sell at short notice.
Investing in a Lump Sum vs. Dollar Cost Average
Whether for a retirement plan or otherwise, calculating dollar cost is a good way to avoid trying to time the market, that is, by trying to buy when the price looks particularly attractive. Dollar-cost averaging is the practice of putting a fixed amount into an investment on a regular basis, usually monthly or even biweekly.
Making a lump sum investment is about timing the market, whether that is your intention or not. Dollar cost averaging, on the other hand, is about hedging your bets in terms of timing. Your performance may or may not lag behind a lump sum investment, but it may be less stressful than wondering whether you made a lump sum investment at the right time.
An excellent example of dollar-cost averaging is investing through an employer-sponsored retirement plan, such as a 401(k). You contribute a fixed amount to the plan each pay period. This amount is invested in the plan based on your investment choices. For investors with a longer time horizon, this type of investing can yield nice savings over time through the “miracle of compounding.”
One of the things that may be in favor of a lump sum investment is that putting some cash aside in a money market or high-yield savings account may provide minimal returns. If current interest rates on low-risk cash accounts are near zero, your opportunity cost is low. However, if interest rates are higher, investing a lump sum may be less attractive because you could otherwise earn cash on your uninvested balance.
A lump sum investment in one or more securities does not 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 sound investment principle and the money invested at once 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 over time, if warranted.
Investing in a lump sum and calculating dollar costs are not mutually exclusive
It is common for an investor to have the option to invest through dollar-cost averaging and a lump sum over their lifetime. Different situations arise at different times.
For example, you regularly contribute diligently to your company’s 401(k) plan. But then you receive a lump sum and you decide to invest that money all at once. This is a good opportunity to rebalance your overall portfolio, if necessary. You can direct new money from the lump sum into asset classes that may be underweight, without having to sell a large position and potentially realize a capital gain.
If you have a concentrated position in a stock, perhaps because you receive share-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.
In short
It’s easy to get caught up in the question of whether investing in a lump sum or gradually using dollar-cost averaging is better. In some cases, the options available to you may be determined by your financial situation and cash flow.
Whether you invest a lump sum, dollar-cost averaging, or a combination of both, it’s important to invest according to your financial plan and your risk tolerance.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
