Even people convinced that they need to own more stock are finding it more difficult than ever to buy now. Many are tempted to hold out for a market dip, but doing so means potentially missing out on a continual rise.
For professionals in their prime working years, it's a bit easier to make a rational decision. Once you have set aside enough cash for emergencies and large upcoming expenses, the next step is putting excess cash to work by investing in an appropriate long-term allocation. There are two fundamentally different investing methodologies that may help you formulate a strategy: lump-sum investing and dollar-cost averaging.
Lump-sum investing: Lump-sum investing means taking the plunge by investing your bonus and other extra cash all at once. Dollar-cost averaging calls for systematically investing equal dollar amounts at regular intervals, such monthly installments, to diversify the timing of your entry into the market. It's taking baby steps versus one giant leap. So which method suits you?
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For people receiving large bonuses or tax refunds, and with excess cash on the sidelines, putting all of those funds into an investment account at once takes a bit of courage. But they will be happy to know that lump-sum investing has proven to provide better long-term returns. A 2012 Vanguard study found that, on average, lump-sum investments outperformed the installment approach across 12-month rolling historical periods approximately two-thirds of the time. During a 36-month interval, lump-sum investments outperformed over 90 percent of the time.
The reason is because stock markets tend to rise over time – the Standard & Poor's 500 Index, for example, has increased in 28 of the past 37 years. This makes intuitive sense because when markets rise, putting your money to work early promotes higher returns. Since statistics favor lump-sum investing, jumping into the market with both feet can be a good idea — if you can handle the prospect of a market downturn immediately after investing your bonus.
Of course, every rule has exceptions and it's not always about the numbers. By investing the total bonus all at once, a person runs the risk of buying at the market's peak, which can be unsettling for a more emotional and conservative investor. As with nearly all investments, people need to be patient and disciplined to see a significant return.