Lump-sum investing: Key points
- Dollar-cost averaging may reduce some risks of investing.
- Lump-sum investing gives your investments exposure to the markets sooner.
- Your emotions can play a role in the strategy you select.
Investing strategies
How to invest a lump sum of money
Investing a lump sum of money comes down to the question of your tolerance for risk.
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Dollar-cost averaging
What is a lump-sum payment?
A lump-sum payment is a single, large amount of money received at one time (rather than in installments or over a period). This type of payment can come from sources such as inheritances, bonuses, settlements, or even retirement payouts. Understanding lump-sum payments is crucial to making informed financial decisions, especially when considering investment strategies. For instance, if you're going through the inheritance process, you might be wondering how to invest your inheritance to maximize its growth potential.
Should I take a lump-sum payment?
When considering a lump-sum payment, it's essential to weigh both your immediate financial needs and your long-term goals. For instance, if you're nearing retirement or have recently inherited funds, this decision can have a profound impact on your financial security. Taking the time to assess your current financial situation and future aspirations will help you make a more informed choice.
An important factor to evaluate is the tax implications of a lump-sum payment. Depending on the source of the windfall, you may owe taxes on some (or all) of the proceeds received. Make sure to account for any potential tax bills and hold that money back from investing. Lump sum taxation refers to the tax you may owe on a large, onetime payment. Depending on the size of the payment and your current tax bracket, the tax liability can be either small or substantial. If the tax liability is large, it could significantly reduce the net amount you receive, making it necessary to understand the potential tax consequences before deciding.
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The lump-sum investment approach vs. dollar-cost averaging
Lump-sum investing involves investing a large amount of money all at once, which can result in immediate gains if the market is rising. However, it also carries the risk of entering the market at a high point and potentially experiencing significant losses. On the other hand, dollar-cost averaging involves investing a fixed amount at regular intervals, which can reduce the impact of market volatility and could be a safer approach for risk-averse investors.
What is a lump-sum investment?
When you decide to invest a lump sum, you're choosing to put a large amount of money into the market all at once, rather than in smaller, regular installments. The primary advantage of lump-sum investing is the potential for higher returns over time, as the entire amount benefits from compound interest from the start. This can be beneficial in a rising market, where the value of your investment can grow more rapidly.
Entering the market at a high point can lead to significant losses if the market experiences a downturn shortly after your investment. This is why it's vital to consider factors such as your risk tolerance, investment horizon, and current market conditions before deciding. If you're comfortable with the potential for short-term volatility and have a long-term investment horizon, investing all at once might be the right choice for you. On the other hand, if you prefer a more conservative approach, you might explore investing over time through strategies like dollar-cost averaging.
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What is dollar-cost averaging
Dollar-cost averaging involves investing a fixed amount of money at regular intervals, such as monthly or quarterly. This strategy can reduce the impact of market volatility by smoothing out the purchase price over time. For instance, if you receive an inheritance and decide to invest a lump sum gradually, you might invest $1,000 each month for 6 months. This way, if the market fluctuates, you'll buy more shares when prices are low and fewer shares when prices are high, potentially lowering your average cost per share. One of the key benefits of dollar-cost averaging is its ability to mitigate the risk of investing a large sum at the wrong time, such as during a market peak. For instance, if you start investing $1,000 each month, you might end up buying 100 shares at $10 each in one month, and 80 shares at $12.50 each in the next month. If you decide to implement dollar-cost averaging, you can either automate your investments or work with an advisor who can set up a strategy and provide ongoing support.
However, it's important to note that dollar-cost averaging may result in lower returns over the long term compared to lump-sum investing, especially in a rising market. If the market is trending upward, investing the entire amount immediately could lead to higher gains. This is why it's crucial to consider your investment horizon and risk tolerance when deciding between dollar-cost averaging and investing all at once.
For example, if you're a young investor with a long-term horizon and a higher risk tolerance, lump-sum investing might be more suitable. Conversely, if you're nearing retirement and prefer a more conservative approach, dollar-cost averaging can provide a safer and more stable path to achieving your financial goals.
Where to invest a lump sum of money?
Other important consideration is your risk tolerance, time horizon, and investment strategy. After reviewing those and your goals for the lump sum, you can decide which investments make the most sense.
If you want to invest a lump sum, there are several investment options to consider. Stocks can offer the potential for high returns, making them a popular choice for those with a higher risk tolerance and longer time horizon. Bonds, on the other hand, can provide a steady stream of income and act as a buffer against stock market volatility. Exchange-traded funds (ETFs) offer a diversified approach to investing, allowing you to spread your risk across a wide range of assets. Each of these investment options has its own set of benefits and risks, so it's important to choose the ones that align with your financial goals and risk tolerance.
Is it better to invest a lump sum or monthly?
Our research indicates that it's wise to invest a lump sum immediately (PDF)1
What if markets are going up?
If markets are trending upward and you think you'd regret the opportunity cost of missing out on potential gains, it makes sense to implement a strategic asset allocation as soon as you can.
History shows that investors who took such a risk have been rewarded with positive returns over the long run that could be greater than the expected return of cash investments.
…But what if they go down?
You may be thinking: What if I invest this huge sum of money at once and the market takes a downturn soon after? What happens to my returns then?
If that's your mindset, dollar-cost averaging may be the strategy for you. In other words, you want to minimize the downside risk.
It's important to weigh your emotionally-based concerns carefully against what the research shows:
- The lower expected long-term returns of cash compared with stocks and bonds.
- Delaying an investment is itself a form of market-timing, something few investors can do successfully.
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1Source: Vanguard, Cost averaging: Invest now or temporarily hold your cash? (Finlay & Zorn, 2023).
All investing is subject to risk, including the possible loss of the money you invest.
Dollar-cost averaging does not guarantee that your investments will make a profit, nor does it protect you against losses when stock or bond prices are falling. You should consider whether you would be willing to continue investing during a long downturn in the market, because dollar-cost averaging involves making continuous investments regardless of fluctuating price levels.
Diversification does not ensure a profit or protect against a loss.
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