Have you recently found yourself with a large amount of cash and need to decide how to manage the funds? If you receive annual bonuses or are a 1099 employee, this may be a decision you face regularly. Or you may be facing this decision for the first time if you have received an inheritance, a large tax refund or have liquidated stock options.
How do you know which strategy for managing your money is best?
Debt Management and Savings
If you have a large lump sum, you may start by reviewing your overall debt and consider using a portion of the sum to pay off debt and another portion to invest. By paying off your debt, you know you’ll save yourself the interest on the debt that you’re paying off. By investing the remainder, you avoid the potential pitfalls of leaving large amounts in savings, such as low-interest rates and/or the urge to spend the money on things that don’t support your goals.
If investing all or a portion of your cash is part of your plan, two options you may be considering are a dollar cost averaging investment strategy or a lump sum investment.
Dollar Cost Averaging
Dollar Cost Averaging (DCA) is the practice of investing a set amount of money consistently over a set amount of time rather than making one large investment a single time. The thought behind DCA is that you will receive more shares when you purchase in months when the market is down and fewer shares when you purchase when the market is higher, but you’ll have less risk of making a large investment at the wrong time or prior to a market correction.
Though you may be minimizing risk with this method, you could also be minimizing opportunity.
DCA should not be confused with systematic savings and systematic investing. You may still invest a certain amount of money each month or period that you receive/earn it (such as investing in your retirement plan) but it’s different than DCA because you’re not holding back a large sum of money to specifically implement the DCA strategy.
Lump Sum Investing
Lump sum investing is putting your entire investment amount into the market at the same time rather than breaking it up into smaller portions. The potential benefit of lump sum investing is that the sooner you invest, the longer your investment has to grow in the market. Keep in mind that your investment risk should correlate to your investment timeline.
If you receive a lump sum during a time when the market is down, you could look at it as an opportunity to buy something “on sale.” Remember the saying that it can be beneficial to be greedy when others are fearful and fearful when others are greedy. If you invest when the market is lower, you can benefit when the market increases--so don’t bypass the opportunity to invest during these times.
Which Strategy Wins?
Winning can mean different things to different people. If you are a very conservative investor, the mental benefits of dollar-cost averaging may be the best strategy for you even if you see lower returns.
If the best return is what you seek, lump sum investing may be the better strategy. According to a recent MarketWatch article, “looking at every 12-month period from 1926 to mid-2014, a lump-sum investor targeting a 60% equity and 40% bond allocation would have outperformed a dollar-cost averaging approach nearly 57% of the time, earning an average return of 9.75% for the average 12-month period.”
If they had used a 12-month dollar-cost averaging approach, it “would have resulted in average gains of…5.17%.”
Work with your financial advisor to determine which strategy makes sense for your situation. There are risks in saving and investing, but understanding your appetite for risk and the steps needed to meet your long-term goals can help you determine which strategy is the best for you.
Sources available upon request.
Marc C. Shaffer, CFP®, AIF®, EA, is Principal of Searcy Financial Services, Inc., a fee-only registered investment advisory and financial planning firm located in Overland Park. For additional information, visit www.SearcyFinancial.com or call 913.814.3800.
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