Lump sum or not: What’s the best way to invest your year-end bonus?
Many corporate employees recently received their 2020 performance bonus. Others, especially at many large companies, will get them over the coming weeks. While the downturn in last year’s economy may have cut into these annual awards for some, others will receive tens, perhaps hundreds of thousands of dollars. So, when should they invest these funds?
During the market’s remarkable run over the past decade, I’ve had conversations every year with people concerned about committing even more money to a stock market that’s already at record highs. These concerns were magnified in 2020 by the fear and uncertainty of the global pandemic, which led to a historically volatile year. This year is no different. Even with an economy poised to rebound in 2021, some are wondering if they should hold off for now and wait for a material market pullback before deploying excess cash.
The risk of attempting to time the market is that tucking that bonus away in a savings account may mean missing out on strong returns if the market continues to grow. Fortunately, there is a way to maneuver around this issue and invest that bonus or any extra cash into a long-term financial plan.
There are two fundamentally different investing methods that can help anyone make this call: lump sum investing and dollar cost averaging. Both are sound investing approaches. Regardless of which method you choose, both strategies require you to identify an appropriate long-term investment allocation, stick to the game plan, and avoid hindsight bias by maintaining a long-term perspective.
Lump sum investing means exactly that: taking the entire bonus – whether it’s $10,000 or $100,000 – and investing it all at once. On the other hand, dollar cost averaging calls for systematically investing equal dollar amounts at regular intervals. This method, usually a monthly or quarterly installment plan, allows a person to take periodic steps and may reduce the probability of extreme outcomes over time, whether positive or negative. It can bring more peace of mind to someone who has difficulty investing a large chunk of their wealth and help investors stick to their plan, especially during volatile market periods.
To help those on the fence, here’s how both methods work:
Lump Sum Investing
Investing a large sum of cash all at once is scary for some. But those who want to go this route should know that lump sum investing has proved to provide better long-term returns more times than not. One study found that, on average, lump sum investments outperformed the dollar cost average approach across 12-month rolling periods from 1926-2011 approximately two-thirds of the time. During a 36-month interval using the same rolling 10-year time frames, lump sum investments outperformed over 90% of the time.
The reason is simple: Stock markets tend to rise over time. The S&P 500 index, for example, has risen in 31 of the past 41 years. So, putting money to work as soon as you receive it often generates higher returns than waiting.
With this information in hand, if you are prepared to handle the possibility of a market downturn immediately after investing your bonus, lump sum investing can be a good idea. But this isn’t the answer for everyone, and none of us can predict the future. If a bear market is looming, it could take years for any near-term investment to generate any significant returns. As with nearly all investments, people need to be patient and disciplined to see a significant return.
Dollar Cost Averaging
This method is often a better solution for people with a lower risk appetite who are more concerned with protecting their portfolio than the upside potential offered by a growing market over the long term. In effect, this strategy is similar to making regular contributions to a 401(k) or other retirement plans. With this systematic approach, dollar cost averaging can help investors stick to a game plan without second-guessing their decisions or getting too emotional as market conditions change.
There are other advantages, too. It enables investors to minimize the downside risk of a large, one-time investment and take advantage of the market’s natural volatility by spreading out your entry points.
While these investors may sacrifice some growth, many prefer the dollar cost averaging approach because it may help reduce the chance of significant losses. By maintaining a consistent and disciplined strategy, the average purchase price of stocks often evens out over time due to price fluctuations. Ultimately, dollar cost averaging, with its more methodical approach, enables many people to sleep easier by mitigating both risk and stress.
The Bottom Line on Which Method to Choose
Whether you choose a lump sum or dollar cost averaging approach, it’s always important to remember to maintain a long-term view. It’s a common pitfall to react to short-term volatility – and we certainly saw some people bail on their investment strategy at the wrong time during the beginning of the pandemic. Instead, sticking to a plan and consistently adding to your portfolio should work well over time, no matter which method you choose.
First Midwest has ideas to help you get started. Visit FirstMidwest/Wealth to find an Advisor.