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Advantages and disadvantages of lump sum investment

As investors, we often hear the virtues of investing gradually over time to build wealth. But sometimes we are faced with investing a lump sum.

Lump sum investing means that you take all or most of your investable money and invest it all at once. A lump sum can be $10,000, $50,000, $200,000 or any other large amount depending on your circumstances.

You could end up with a lump sum for a number of reasons. Perhaps you received an inheritance. If you recently left an employer and transferred your 401(k) to an IRA, you will need to invest this lump sum.

Advantages and disadvantages of equity investment

Lump sum investing has a number of pros and cons that investors should be aware of.

Advantages

  • For a long-term investor, it pays to grow your money as soon as possible. With normal market trends increasing over time, you can expect to overcome any difficulties along the way over the next 15, 20, 30 or more years.
  • Investing via a lump sum means you don’t have to try to figure out the best time to make periodic investments. You can set up your wallet and let it grow.
  • A 2021 Northwestern Mutual Life Study have shown that lump sum investing generally outperforms average purchase over various time periods. Just keep in mind that this is based on past historical performance, so it doesn’t necessarily mean it will remain the case in the future.
  • Depending on what you invest in, a lump sum could reduce the overall commissions you may incur compared to smaller periodic investments.

The inconvenients

  • To make a lump sum investment, you must have a lump sum to invest. If you receive a lump sum or have accumulated a large sum to invest, that is fine. Otherwise, you will have to raise funds by selling existing assets or in some other way. This process could negate the benefits of a lump sum investment.
  • A lump sum investment is made at a given time. The price you pay for the investment(s) can be high or low. If you invest when prices are high, you run the risk of incurring a loss if you have to sell short.

Lump-sum vs. dollar-cost averaging

Whether in a retirement plan or otherwise, cost averaging is a good way to avoid timing the market. Averaging is the practice of regularly investing a fixed amount of money in an investment, usually once a month or even every two weeks.

Making a lump sum investment is all about timing the market, whether or not that is your intention. Averaging, on the other hand, is all about hedging your bets in terms of timing. Your performance may or may not lag behind a lump sum investment, but it may be less stressful than wondering if you made a lump sum investment at the right time.

A great example of a periodic fixed-sum purchase is investing through an employer-sponsored retirement plan, such as a 401(k). You would contribute a fixed amount to the plan each pay period. This amount would be invested in the plan based on your investment choices. For investors with a longer time horizon, this type of investment can build up a nice nest egg over time thanks to the “compounding miracle”.

One of the things in favor of a lump sum investment is that keeping money aside in a money market or savings account will provide a minimal return. Current interest rates on low-risk cash accounts are close to zero in most cases. This is a drag on overall return for an amount you might otherwise invest as a lump sum.

A lump sum investment in one or more securities does not mean that you have to leave that money invested the same way forever. Rebalancing is a sound principle of investing and money invested as a lump sum should be part of this rebalancing process. Stocks, mutual funds or ETFs purchased as part of a lump sum can and should be exchanged for other securities if warranted over time.

The fixed investment and the average purchase price are not mutually exclusive

It is common for an investor to have the option of investing both via cost averaging and via a lump sum over their lifetime. Different situations arise at different times.

For example, you could contribute diligently to your company’s 401(k) plan on a regular basis. But then you receive a lump sum and decide to invest that money as a lump sum. This is a good opportunity to rebalance your overall portfolio, if necessary. You can direct the fresh money from the lump sum to asset classes that may be underweight.

If you hold a concentrated position in one stock, perhaps because you receive stock-based compensation from your employer, the lump sum can be used to invest in other types of investments to offset the impact of the concentrated position.

At the end of the line

It’s easy to get caught up in a question like whether it’s better to invest in a lump sum or to gradually use the periodic purchase by fixed sums. In some cases, the options available to you may be dictated by your financial situation and liquidity.

Whether you’re investing as a lump sum, averaging, or a combination of the two, it’s important to invest according to your financial plan and risk tolerance.

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Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. Further, investors are cautioned that past performance of investment products does not guarantee future price appreciation.