Most of us have dreamed about suddenly receiving a large pile of money.
But, if you're financially responsible, you may also be wondering whether to invest all at once or to dollar-cost average. Which one is the better financial decision?
That's what a listener of the Clark Howard Podcast recently asked.
Investing: Lump Sum vs. Dollar-Cost Averaging
That's what a listener wondered on the Dec. 16 podcast episode.
Paul in Michigan said: “I’m very fortunate to be receiving a large lump-sum pension. I’m confident in the stock market and plan to invest most of it in a variety of stock market index funds within my 401(k). I read, see and hear conflicting advice on whether to invest it all at once or dollar-cost average. What is your advice?”
The answer to this question depends on your personality and how comfortable you feel with risk.
If the historical math favors investing a lump sum as soon as possible, the current state of the market may tilt the odds even further.
As of this writing, the S&P 500 has declined 18.8% so far in 2022.
While there’s no guarantee that the market is going to be in the green in 2023, the stock valuation of the average American company is more reasonable compared to earnings and profits than it has been in years.
But at some point, inflation will be closer to historical norms, the Fed will stop raising interest rates and the economy will be back in the green again.
Investor Psychology: A Second Look
Keep in mind that if you’re investing for the long term, even if you invest a lump sum and see an immediate decline, you’ll have time for it to grow. Plus, you may feel bad if you decide to wait and the market spikes.
“The psychological, though, is very important. Because people can feel devastated if they worked hard through a working lifetime, get that lump sum and then bam, it gets blown away in short order,” Clark says.
“So if you would lose sleep, you would be twisted in knots if there was a big decline right after you put in a lump sum, go with dollar-cost averaging as a way of peace of mind, putting this money aside for your future.”
Clark’s 90/10 Rule
Paul sounds like a practical person.
But for the average person, deciding to dollar-cost average can also lead to poor decisions. The longer you’re holding that money in your bank account, the more likely you are to use it on something you don’t need. And if you’re skimming off a little here and a little there, over time, you may not realize how much you’ve spent.
However, if you come upon a lump sum of money, Clark doesn’t think you should invest every single dollar. He wants you to take 10% and spend it however you want.
Use the 10% to go on the vacation of a lifetime, buy the newest Corvette or invest in your friend’s dog toy startup if that’s what you want to do.
Clark compares this to going on a diet. If you never have a “cheat day” or some way to reward yourself occasionally, you’ll probably backslide eventually — sometimes with disastrous consequences.
Deciding between investing a lump sum in one aggressive splash or dollar-cost averaging is a personal choice. The math says to put it all in as soon as you can.
But if that’s going to make you lose sleep — especially if the market declines after you’ve invested — maybe you should consider dollar-cost averaging.
If you’ve received a lump sum all at once, also consider Clark’s 90/10 rule and spend 10% of it on anything you want.
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