Investing a Lump Sum: Tiptoe or All In?
Receiving or accumulating a lump sum of cash can result in a major investment quandary - "Do I investment this all at once, or invest it over time?" This lump sum of cash can come from selling a business, an inheritance, or a pension lump sum payout. It can also result from having sold investments (when stocks got choppy), and now wondering how/when to get back in.
Regardless of the source of the lump sum of cash, the question is:
"Should I invest this all today or invest it slowly over the next year or two?"
I have read studies on this topic over the years all with similar conclusions - go "all in". Most recently, Vanguard evaluated this and also concluded that the best approach is to invest it all at once. Immediate investment led to greater portfolio values approximately two-thirds of the time. On average, immediate investment outperformed systematic implementation by anywhere from 1.45% to 2.39% over the one-year time period studied.
Even when the market is considered "overvalued", a lump sum strategy beats a dollar cost averaging strategy over the long term.
This is somewhat of an obvious conclusion considering the stock market rises three out of every four years. However, in practice going "all in" can be a very hard thing to do because people don't live within the logic of an excel spreadsheet. Also, while historically "on average" going all in has been the best approach, you may certainly not get the average result. You only have one shot and may not be able to sustain the risk of dumping a huge lump sum of cash into stocks only to see them plunge 50% over the next year.
For example, imagine selling your beloved business for $1 mm at retirement, and you decide to invest it. The market appears to be "overvalued", but having read the studies, you invest it anyway. Then a 10% drop occurs during the first week after investing it. Naturally, this results in plenty of regret and consideration of getting out before losing a lot more! Losing $100,000 in one week is enough to give anyone pause. Of course, logically we should NOT expect positive results in a week, but again we are not a spreadsheet!
Therefore, this is where a tiptoe strategy can make sense - in helping to minimize regret and helping investors to stick to an investment plan without bailing out. Sure there is a cost to this...likely lower returns. However, the cost of going all in, and then panicking after one week is even more costly!
A tiptoe strategy means taking the money you have earmarked for stocks, dividing it by 12 to 36 (months) and placing that amount into the market each month until you are fully invested. It can also be known more popularly as a dollar cost averaging strategy.
Younger investors with a decade or longer until retirement should consider the all in approach, whereas soon-to-be retirees should consider the tiptoe approach in order to avoid sequence of return risk. This is the risk of receiving poor market returns early in retirement while simultaneously needing to take large withdrawals. Sequence of return risk can have serious ramifications on the value of one's portfolio and its ability to generate income through the retirement years.
Determining which approach to use when investing a large sum of cash can be daunting. Hopefully, this have given you some of the pros and cons associated with each.