Why to Dollar-Cost Average a Lump Sum
If you receive a windfall and want to invest the funds in the markets, should you dollar-cost average or invest the whole lump sum immediately?
Those who read enough financial literature would probably invest the lump sum right away because it's mathematically prudent to get the full amount invested as early as possible. But it may not be smart to choose the lump sum approach. Here are some reasons it makes more sense for some people to invest periodically instead:
Markets are volatile. The math says a lump sum investment will win more often, but there's always a chance that the buy order will be made right at a short-term peak. The worst outcome isn't the financial hit, but the emotional one. How will you react if the market declines 10 percent, effectively wiping out a huge portion of your liquid assets? Will your resolution to keep invested in the volatile markets waver? After all, your savings rate and discipline in staying the course will ultimately influence your chances of a comfortable retirement the most. Don't let anything undermine this.
The difference between investing the lump sum and dollar-cost averaging periodically, say once a month for a year, is going to be small. After all, cash still earns a small return. Furthermore, look at any stock market performance chart for the long term and you'll realize that any short-term events (up or down) are going to become a blip on the radar. If this is at all a concern, don't let the potential of a market decline at the wrong time affect your behavior.
Investing periodically will keep you more interested in investing advice. Even the pros learn new theories all the time. Maybe you will find out about a fund that fits your objectives better, or perhaps you didn't know you could pay less tax by placing investments in tax-deferred and taxable accounts based on their tax treatment. You may even find out there are more tax-deferred options you didn't know were available to you when you were thinking about investing the lump sum. Sure, you can sell the investments and still take advantage at a later time, but then there will be potential tax consequences and wash sale rule restrictions that may complicate the issue.
The extra time will allow you to become more comfortable with the markets and your asset allocation. It's one thing to look at all the theories and come up with a number that seems to fit your situation, but it's quite another to actually live through the asset allocation that you've decided on. The optimal stock and bond allocation is the one that you are able to maintain without losing too much sleep, and you really can't verify what it is until the allocation is battle-tested.
Spreading out your investments will give you more opportunities to tax-loss harvest. The volatility of the markets will mean that you will buy at different price points, giving you a different cost basis that may allow for tax-loss harvest opportunities. Just remember to keep track of your tax losses and share any temporary market declines with Uncle Sam while keeping the gains for yourself.
Success in building a solid nest egg for a comfortable retirement may occasionally involve choosing a path that makes no sense mathematically. The key is to know what works best for you over the long term and how each decision will affect the overall picture. There's more than one path to financial freedom.
David Ning runs MoneyNing, a personal finance site that shares money moves you can make to significantly increase your chances of having a comfortable retirement. He likes to share simple changes that anyone can make, such as picking the best online savings account and figuring out whether a 0 percent balance transfer credit card makes sense.
