Congratulations! You have a lump sum of money and you want to invest it! That’s a great decision. But what should you do with it? Should you put ALL of it into the stock market at once? Or spread it out over time, and invest a bit each month? No matter whether the stock market is at a record high, or whether it has fallen recently, it can be a hard decision to make. No one wants to put in a huge sum of money, and then have it worth less money a few days or weeks later.
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When You Might Have a Lump Sum to Invest
There are many times in life when you are in this situation, having to decide whether to invest all at once or over time.
- You get an annual bonus at work
- You get a big commission payment for a major project you worked on
- You maximized your contributions to tax-advantaged accounts last year, and then saved up for the next year, and now you have more contribution room because it’s January 1st
- You receive a gift of money – graduation, wedding gifts, birthday, or other holidays
- You inherit money
- You sell a business
- You get a big tax refund
- You downsize your house, and have a lot of money left over after buying a new home
- You win the lottery (if you “win big” please see a fee-for-service advisor to give you customized advice!)
No matter how you got this lump sum, you want to make sure you do the right thing.
When is Stock Market Investing a Bad Idea?
If you have outstanding high-interest debt, you are unlikely to make more in investing than you are paying in interest costs. Credit cards often charge in the neighbourhood of around 20% interest on outstanding balances. Payday loans are worse. Over time, the stock market has returned an average of about 8%. But there’s no way of telling whether the next year will be outstanding, or a crash. On the other hand, with debt you know exactly how much interest you’ll be paying. So pay off those high-interest loans before investing.
If you are going to need those funds within the next few years, investing may not be the right choice for you. For example, saving for your teenager’s education fund, saving for a downpayment in 3 years, or a wedding budget for next year, high-risk investing is not a wise move. If the stock market drops by 20% the year before your daughter starts college, you can’t ask her to delay for a few years until her education fund recovers.
In these types of scenarios, you might consider a high-interest savings account, GICs, or bonds.
Benefits of Investing a Lump Sum All at Once
There are several benefits to investing your money all at once, rather than spreading it out over time.
If you invest it all at once, you won’t be tempted to spend it. Money sitting in your chequing account has a way of disappearing, if you know what I mean! An extra splurge here, a nice evening out there, a mini vacation… Soon it’s not as much anymore, and you never got around to investing it.
In addition, life gets busy, and even with the best of intentions you might not get around to investing it diligently on the first of every month, or whatever your plan might be.
Most importantly, on average the stock market goes up over time. So the earlier you invest, the more time your money has to grow. As the old adage goes, it’s “time in the market, not timing the market” that builds wealth.
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Benefits of Investing Over Time (Dollar Cost Averaging)
While it’s true that the stock market does go up over time, it’s possible that this is not one of those times. If you invest a little each month over several months, this is called “dollar cost averaging”. That means, if the price of your chosen investment goes down, but you continue to invest the same dollar amount, you actually get more shares of that investment.
Let me give you an example.
You want to buy an investment, that we’ll call ABC, and you have $6,000 to invest.
When Investing Over Time Works…
You can invest all $6,000 today, at the current price, which happens to be $25. You will get $6,000 ÷ $25 = 240 shares of ABC.
Alternatively, you consider dollar cost averaging $1,000 each month for 6 months.
In the following scenario, you can see the price of ABC investment falls at first, then starts to pick up again. We don’t invest exactly $1,000 each month, because we can’t buy fractions of a share. So we save up that extra bit and invest at the end.
|Investment||Number of Shares|
In total, we have 246 shares. Our $6,000 investment ÷ 246 shares means we spent on average $24.39 per share.
In this scenario we came out ahead of the lump sum investing, which got us 240 shares for the same $6,000 investment.
However, when you saw in month 2 that ABC investment fell from $25 to $22, would you still go ahead with your plan and buy more? Or would you second guess yourself and invest in something else? It’s so hard to get past the psychology of investing in a down market, to follow the plan.
… And When it Doesn’t
But if the stock price increased every month, we would end up with fewer than 240 shares. If the stock price rises by $1 each month ($25 now, $26 in month 2, then $27 in month 3, and so on) we would only purchase 219 shares in total. Substantially fewer than the 240 shares we got by investing it all in one lump sum! Our average cost per share was $27.41, instead of the original cost of $25.
|Investment||Number of Shares|
Since we just don’t know what the stock markets will do in the future, it’s totally a guess whether this dollar cost averaging strategy will work in our favour or not.
In addition, if ABC investment paid out dividends over those 6 months, we would have missed out on those by not being fully invested from the start. Even in a slightly falling market, dividends can still make investing up front worthwhile.
What the Experts Say about Investing a Lump Sum
Studies have shown that at least two-thirds of the time, it is better to invest all your money as a lump sum.
Vanguard, one of the world’s largest investment management companies, studied this exact question, in “Dollar-cost averaging just means taking risk later“. While it’s a little dated, published in 2012, it does include the last major downturn in 2008 in their analysis. Their comprehensive study looked at markets in the U.S., Australia, and the U.K., and also various combinations of stocks and bonds in each country. They looked at holding periods ranging from as short as 1 year to as long as 30 years.
Morningstar, another investment company, also studied this issue in their 2019 report “Dollar-Cost Averaging: Truth and Fiction“. Their results are event stronger. Nine times out of ten, investors would have had more money at the end of 10 years by investing in a lump sum at the start, rather than spreading it out over time. Startlingly, they examined the 2008 period and still found this to hold true! An investor who chose to invest in a lump sum just before the 2008 crash still ended up wealthier than one who chose dollar cost averaging. And this is for a 100% equity investment or a portfolio with 60/40 equity/bond split.
What [dollar cost averaging] investors don’t realise is that they are, in fact, making a market call by not making a lump sum investment. They’re betting that the stock market will go down for a while, and then come back up later.Morningstar
Of Dollars and Data Blog
Analytics manager and investor Nick Maggiulli, who blogs at Of Dollars and Data, has done his own research on How to Invest a Lump Sum. Looking at a 60/40 stock/bond portfolio, and investing periods between 1960 and 2018, he gets similar results. That is, dollar cost averaging underperforms lump sum investing 80% of the time. Nick goes on to examine dollar cost averaging over a longer period, such as 24 months instead of 12 months. The likelihood of outperforming a lump sum investment get even slimmer.
Personal Finance Bloggers
We had an interesting discussion about lump sum investing versus dollar cost averaging on Twitter. If you have $6,000 to invest in January for your TFSA (Tax Free Savings Account), should you invest it all at once, or invest $500 each month all year? The vast majority of responses were in favour of investing the lump sum.
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Dollar cost averaging means you get more shares when the price goes down, and fewer when the price goes up. For some people, the alternative – investing a large lump sum all at once – seems like more of a gamble. Is now the “right time” to invest, you might be thinking. The reality is that no one knows what the market will do in the future. Not next week, not next month, not next year.
Evidence clearly shows that most of the time you’re better off to invest your money as a single lump sum right now. If your goal is to maximize expected returns, this is the strategy for you. However, if the idea of investing it all at once gives you anxiety, and thoughts of a downturn would fill you with regret, then use dollar cost averaging instead. It’s better to invest in the way you feel most comfortable, than not invest at all.
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Please note that the information here and elsewhere on my blog is for education and entertainment purposes only. Any examples are for demonstration purposes and may not apply to your personal situation.