Many corporate executives recently received their 2021 performance bonus and others will get them over the coming weeks. Most will earn tens of thousands, perhaps hundreds of thousands of dollars. So, when should they invest these funds?
Of course, one immediate concern is the stock market’s current uncertainty. Earlier this month, the S&P 500 dropped a little over 10 percent from its record high while the Nasdaq was off approximately 20 percent. And while it is a difficult decision for many people to invest when the market is swinging back and forth, there is also a risk in tucking away that bonus in a savings account and missing out when there is a rebound.
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.
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 actually proved to provide better long-term returns more times than not. A 2012 Vanguard 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, lump sum investments outperformed over 90% of the time.
The reason is simple: stocks tend to rise over time. The S&P 500 index, for example, has risen in 32 of the past 42 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. This approach enables investors to stick with 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 important to remember to maintain a long-term view. One of the most common pitfalls among investors is a knee-jerk response to short-term volatility. Too often these people turn into day traders and lose sight of their long-term focus, causing them to sell during market dips.
Instead, sticking to a plan and consistently adding to your portfolio should work well over time, no matter which method you choose. Try to remember the common adage that “time in the market is more important than timing the market.”