Many professionals and business executives are in the midst of receiving their 2016 performance bonuses, and plenty will receive hefty six-figure checks. But as they search for the best way to prudently invest this money, many are wary of plunking down such a large amount in a stock market at all-time highs.
While the Dow Jones Index continues to cruise past the 20,000 mark, they fear a downturn that could easily wipe out a year's worth of hard work.
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?
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.
Dollar-cost averaging: Despite data suggesting dollar-cost averaging may not be as likely to enhance returns in the long run, many investors prefer this strategy as a risk-management technique. Often those who choose dollar-cost averaging are more concerned with downside protection than upside potential. Keep in mind that millions of people make regular contributions to a 401(k) plan or other retirement scheme, which effectively is the same strategy as dollar-cost averaging.
While statistical analysis favors a lump-sum investing approach, dollar-cost averaging has several advantages. For starters, it allows investors to minimize the downside risk of a large, one-time investment and take advantage of the market's natural volatility. Not only is dollar-cost averaging a good strategy for more risk-averse investors, it also works well during periods of flat stock market performance and bear markets.
And while an investor may sacrifice a little upside, some of my clients prefer the dollar-cost averaging approach because it may prevent significant losses. By maintaining a consistent and disciplined strategy, the average purchase price of stocks often evens out over time due to price fluctuations.
Ultimately, dollar-cost averaging, with its more methodical approach, enables many people to sleep easier by mitigating both risk and stress.
For people with a large amount to invest — and especially for professionals in their prime working years — it's critical to take the long view. One of the most common pitfalls among investors is a knee-jerk response to short term volatility.
Too often these people turn into day-traders and lose sight of their long-term focus, causing them to sell during market dips. Instead, focus on consistently adding to your portfolio over time, whether in lump sums or smaller systematic increments. Try to remember the common adage that "time in the market is more important than timing the market."
— By Ryan Halpern, wealth advisor at Brightworth