Staying invested in the market through dollar cost averaging is usually the best strategy to ensure people will have enough money to last through retirement.
But this strategy has its exceptions when investors receive a bonus from work or a lump sum payment from an insurance claim or tax refund. In these instances, individuals should consider that investing the entire amount might be the best option, said Robert Johnson, president of The American College of Financial Services in Bryn Mawr, Pa. Keeping some of the money in cash and spreading out the allocations over the next few months means you will receive lower returns, since the stock and bond markets will ultimately generate greater returns, even in this volatile environment, he said. Putting skin in the game now will allow you to take advantage of future returns, as interest rates in savings accounts will still be quite meager.
Benefits of Lump Sum Investing
“The answer is pretty clear,” Johnson said. “If your goal is to accumulate the most wealth and you aren't motivated by other factors, invest the entire bonus. A study by Vanguard found that lump sum investing beat dollar cost averaging about two-thirds of the time.”
Extra income that is just a one-time occurrence such as a tax refund should be treated differently than bonuses received every year. Spreading the investment out over dollar cost averaging where you invest by making periodic payments in mutual funds or ETFS could be a better option only if you are more risk averse and are concerned about the volatility in the market, he said.
Employees who receive an annual bonus are often more likely to invest the entire amount at once even though the market can experience downturns, Johnson said.
“Some years they will win, because the markets will advance that year and they will make money on the bonus,” he said. “Some years they will lose, and in effect dollar cost averaging will outperform lump sum investing.”
Over a period of several years, the market tends to rise, leaving investors with more years where they “win” if they put their funds to work immediately, Johnson said.
“In other words, you get more than one draw from the distribution and the law of large numbers is in your favor,” he said.
A study conducted by TIAA-CREF of the 12-month periods ending December 1926 to August 2014 showed that lump sum investing generated higher returns. An investor who had 80% of his funds in stocks and 20% in bonds saw a return of 55.27% from lump sum investing while the dollar cost averaging strategy produced a gain of 18.42% over 12 months. A portfolio consisting of 60% in equity and 40% in bonds produced a similar outcome with a lump sum investment return of 56.61% while a 12-month return generated a gain of 15.38%.
Timing the market or figuring out its future in the short-term can be risky, so investing it before you spend it can be the right strategy.
“There is really no way to know what the market is going to do in the future, so why not put money aside while you have it available,” said Patrick Morris, CEO of New York-based HAGIN Investment Management. “I would not be bullish on bonds here, though. Perhaps the good old Vanguard passive index fund for the S&P 500 is the way to go.”
Dollar-cost averaging can result in “mediocre performance,” said Sreeni Meka, a portfolio manager with Covestor, an online investing marketplace, and managing member of Lakeland Wealth Management in Lakeland, Tenn.
“If you are an individual stock picker, what is the point of buying equities when fundamentals are off?” he said. “If great opportunities are ahead and the economy is coming out of recession, what is the point sticking to cash and investing only an average amount?”
Benefits of Dollar-Cost Averaging
Investing the money immediately does have its pitfalls, because the markets could be extremely volatile like the past two weeks and continue in a downward trend right after you purchase stocks. Investors who are motivated by regret aversion can “hedge their bets by spreading that investment out over time,” Johnson said. “By spreading the investment out over time, you lessen the risk that you committed all of your funds at or near a market high.”
The volatility of the stock market can not only be “confusing”, but also intimidating for many people, so sticking to dollar-cost averaging is important, said Grant Easterbrook, co-founder of Dream Forward Financial, a low cost 401(k) plan based in N.Y.
“Reinforcing the value of putting your bonus towards saving for retirement - rather than spending it is important,” he said. “However, we don't necessarily agree with the strategy of trying to entice people to save their bonus by discrediting dollar-cost averaging."
Instead, investors should focus on the value of compounding interest and the long-term nature of retirement investing where short-term stock market fluctuations do not matter, Easterbrook said.
While investing in the market has its drawbacks, the benefits exceed the weaknesses since a typical individual’s cost of living rises about 50% every decade and 100% every 20 years with a 3.4% inflation rate over time, said Jon Ulin, a managing principal of Ulin & Co. Wealth Management in Boca Raton, Fla.
“If your money is sitting in cash or only high quality short-term bonds, you may not be able to retire when you planned if the returns on your capital are low or nearly non-existent,” he said. “If you are retired and spending 4% or more of your principal and not making any returns, you may be guaranteeing yourself to run out of money over time.”
Too many investors find that their top priority is outliving their savings and retirement portfolio and not the volatility of the market, Ulin said.
“This fear motivates them to stay fully invested, track their results and keep a calm mindset to their financial life,” he said.