How Should I Invest a Lump Sum?
Updated: Dec 29, 2020
Immediate Investment vs. Periodic Investment
There are many behavioral aspects to investing (loss aversion, regret aversion, recency bias, mental accounting, etc.) and these biases often come to a head when investors are faced with the prospect of investing a lump sum of money.
Investing within your retirement plan is typically pretty easy and out of sight, out of mind; you invest on a recurring basis (when your paycheck comes in) and the investments are spread across the allocations that you selected when you set up your 401(k). But what do you do when you are sitting on cash that is in excess of what you need for a rainy day fund and is earning little to no interest in a checking or savings account? Do you invest it all today? Do you invest it gradually every week, month, or quarter until the investment is completed? Most of the difficulty in making this decision comes from a fear that you are investing at the wrong time and that the market is bound to drop in the coming days or weeks. The key is to look at this dilemma from a rational, statistically driven view and come to a decision based on the probabilities that you are presented with.
An article published by Vanguard in 2016 (article) compared the performance of investing immediately vs. investing systematically (i.e. monthly investments) into a portfolio of 60% stocks and 40% bonds using data back to 1926. They found that in 68% of rolling 12 month periods, investing immediately resulted in higher returns than a strategy of investing on a monthly basis for 6 months. The percentage of periods in which immediate investment outperformed systematic investment also increases as you stretch out the systematic period. 92% of the time, immediate investment beat a strategy of investing each month for 36 months. The underlying concept is that, over time, markets tend to go up. Recalling a previous post (Stock Returns Over Different Time Horizons) that looked at data over the last 40 years, 53% of days had positive returns, 63% of rolling one month periods had positive returns, and 78% of rolling 12 month periods had positive returns. Ultimately, when investing a lump sum of cash, the longer the time frame is between investments, the greater the chances are that the cash you have kept on the sidelines will have missed out on positive returns.
Despite these probabilities, it can still be behaviorally difficult to get yourself to fully invest immediately. Two potential ways to mitigate your behavioral hesitance without sacrificing much in terms of longer term investment results are to invest systematically over a short time frame, say every day for 2-3 weeks, or to invest immediately but into a more conservative portfolio than your target portfolio. By investing gradually over a couple of weeks, you aren't "locking yourself into one price" and you mitigate some of the risk of investing at the wrong time without significantly impacting your longer term investment results. By investing in a slightly more conservative portfolio (say 50% stocks instead of 60% and the rest in bonds) you get yourself fully invested, although with lower stock risk, and have more flexibility to sell bonds and buy stocks in the event that you are unlucky and the stock market falls soon after the investment is made. Additionally, if the market continues to climb, stocks will naturally grow as a portion of your portfolio and approach your target percentage.
By utilizing these two strategies, you can mitigate the opportunity cost of sitting in cash, get past behavioral barriers, get yourself invested, and be on your way towards compounding returns.