What is Lump-sum Investing and How does it Work?
Lump-sum investing is investing a large amount of money all at once, rather than by making smaller investments over time. Most commonly, significant lump sums come from selling a business or real estate property, stock options (such as Incentive Stock Options (ISO’s) awarded by your employer), receiving an inheritance, a pension payment, or a divorce settlement. After years of building up a business, owners may receive a large lump sum on the sale of their company. A substantial inheritance may come at any age. Some retirees also elect to receive their pension payment in a lump sum.
Lump-sum investing can be most effective when done in combination with other smart investing moves. For example, funding a retirement account or making a lump-sum purchase of shares of a diversified fund are two ways to invest a large amount of money while limiting your exposure to risk. But remember that however you invest, you’re taking on risk and should expect your account to fluctuate in value.
Lump-sum investing differs from dollar-cost averaging in some key ways. Investing a lump sum comes down to the question of your tolerance for risk. Dollar-cost averaging spreads the risk of investing over a period of time. Lump-sum investing gives your investments exposure to the markets sooner.
How to Invest a lump-sum of money- advantages and disadvantages
There are pros and cons to pursuing a strategy which entails putting all of the money into the market as soon as possible. It’s a decision that can cause anxiety and even lead to losses in the short term. But, despite the risk, the numbers suggest that lump sum investing can be a better choice for long-term investors.
Most empirical research indicates that it’s prudent to invest a lump sum immediately after receiving the funds. According to data from Northwestern Mutual, lump-sum investing outperforms dollar cost averaging by a wide margin.
The Northwestern Mutual study looked at rolling 10-year returns on $1 million starting in 1950, comparing results between an immediate lump sum investment and dollar-cost averaging. For the dollar-cost averaging strategy, the study assumes that $1 million is invested evenly over 12 months and then held for the remaining nine years.
According to the results of the study, for a 100% stock portfolio, the return on lump-sum investing outperformed dollar-cost averaging 75% of the time. For a portfolio composed of 60% stocks and 40% bonds, the outperformance rate was 80%. And a 100% fixed-income portfolio outperformed dollar-cost averaging 90% of the time.
Investing all of your money at the same time is advantageous because you’ll gain exposure to the markets as soon as possible and historical market trends indicate the returns of stocks and bonds exceed returns of cash investments and bonds. Delaying investment is itself a form of market-timing, something few investors succeed at.
Dollar-cost averaging may be best if your goal is to minimize the downside risk of a large investment or to take advantage of the market’s natural volatility by lowering the average price you pay for shares.
Choosing between investing through dollar cost averaging and lump-sum investing comes down to balancing potential performance with your tolerance for risk and volatility. There are many investment strategies available, from aggressive to conservative. The right selection should be customized and depends on the individual’s personal situation and circumstances. It’s important to find the right balance between safety and growth. Safety often comes at the price of reduced return potential and erosion of value due to inflation. On the other hand, if you invest too heavily in growth investments, your risk is heightened.
If you have a long-term horizon, you are in a good position to take on calculated investment risk and there are numerous ways you can manage this risk.
Factors to consider for lump-sum investing
When assessing the investment options where you can invest a lump sum, you want to focus on asset allocation and diversification. This involves the composition of fixed income and equity categories and developing a portfolio that can perform in the long term under a wide range of circumstances.
Tax efficiency can relate to investment turnover in individual stocks or mutual funds that can lead to short- term and long-term capital gains. Mutual funds may have significant embedded gains and in some instances you can pay taxes for economic gains you never realized based on the timing of your purchase and the structure of mutual funds.
If your primary concern is performance, investing all at once through lump-sum investing can equate to higher returns. If you’re nervous about investing your money all at once, investing slower using dollar cost averaging may be a good alternative. It is worth noting that, in general, investors often benefit most from starting off investing by fully funding all of their retirement accounts. Investing a lump-sum into a traditional or Roth IRA retirement account is a good way to save for the future in a tax-advantaged way.