I’m often asked how to invest a lump sum of new cash. Should this money be invested in the markets all at once or dollar-cost averaged (DCA) over time? The answer depends on several factors: where the money came from, the amount relative to your current savings and how it was invested before you received it.
Lump sums can come from several different sources — a pension payout, inheritance, the sale of property or a business, or perhaps winning the lottery. I’ll assume you’re receiving a cash payout rather than an in-kind inheritance of stock or property. In-kind payouts often have tax issues that require the help of a tax professional.
Here are 4 simple rules to help decide on a DCA or all at once strategy.
- What is the size of the lump sum relative to your existing savings? If it is small, regardless of where it came from, invest it all at once and be done with it. My rule of thumb is 20 percent. If a lump sum is 20 percent or less of the amount you have already saved, then invest the entire amount in your existing asset allocation. For example, if you already have $1,000,000 in savings and you inherit another $200,000 or less, put it all in. If the lump sum is greater than 20 percent, go to #2.
- Was this money from an employer pension plan? If the answer is yes, then the cash was recently in stock and bond investments and it should go right back in. For example, if your 401(k) was recently invested 50 percent in stock funds and 50 percent in bond funds before it was liquidated to cash for the distribution, then the cash should go right back into stocks and bonds.
- Was the money from the sale of a business or property? If the answer is yes, then there was a previous business risk attached to that money even though it wasn’t equity risk. In this case, consider investing half of the money in the markets today and DCA the remaining half over the next 2 years. This spreads out the entry-point risk into the markets.
- Was the money inherited, won, or from another source where you had no previous ownership? Here is where DCA works well. I recommend investing 40 percent now and DCA the other 60 percent over the next 3 years. For example, imagine you won $1,000,000 after tax in a lottery. Invest $400,000 this year and $200,000 per year for the next 3 years. This spreads out your entry-point risk.
The guide above provides some good points for the timing of lump sum investing, but it doesn’t discuss where to invest it. That depends on your financial situation — although receiving a lump sum often changes that. Here are a couple of rules to help with investment decisions:
- If the lump sum is 20 percent or less of your current savings as described in #1, then your asset allocation shouldn’t be affected. Simply invest according to your current investment policy.
- If the lump sum is more than 20 percent of your current savings, then you should consider reviewing and revising your overall investment strategy. You can do this on your own by reading investment books, or you can get help from a low-cost investment advisor. Another idea is to visit www.Bogleheads.org and asking advice from this free online community of savvy individual investors.
Receiving a lump sum doesn’t need to be daunting. The investment timing choices are fairly straightforward. The points above will help determine a satisfactory solution and provide you with the peace of mind you’re looking for.