What is lump sum investing?
Thinking about investing a sizeable amount but not sure how to do it? Learn all about lump sum investing, if it's the right investment move for you and the best ways to do it.
What is lump sum investing and how does it work?
Lump sum investing is a strategy where an investor invests a large sum of money into an investment all at once, rather than making smaller periodic contributions over time. The investor commits a significant amount of money upfront, typically from savings, an inheritance, or other sources of funds.
By investing the entire sum at once, the investor gains immediate exposure to the financial markets. This means the investment starts accruing potential returns, and any price appreciation or dividends begin to affect the overall value of the investment.
However, a lump sum investment carries some level of risk, especially if it occurs during a period of high market volatility. The investor's timing becomes critical, since market fluctuations can significantly impact the initial investment. If the market performs well after the investment is made, the returns can be substantial, as shares trade at a higher price. On the other hand, if the market declines, the investor could potentially face short-term losses.
Psychologically, lump sum investing can be challenging for some investors, particularly during uncertain market conditions. There may be concerns about investing a large amount all at once and fear of potential losses if the market takes a downturn shortly after the investment.
On a long-term basis, lump sum investors may potentially have better results compared to a dollar cost averaging investor, especially during bull markets.
Ultimately, the decision between lump sum or dollar-cost averaging depends on factors such as the investor's risk tolerance, time horizon, market outlook, and personal preferences. Some investors choose to use a combination of both strategies to diversify their investment approach.
Lump sum investing example
Suppose you have received a substantial inheritance of $50,000, and you are considering investing it in the stock market. Instead of spreading out the investment over time, you decide to use the lump sum investing strategy and invest the entire $50,000 in a diversified portfolio of stocks.
You conduct thorough research to create a well-balanced investment portfolio that aligns with your financial goals and risk tolerance. After careful consideration, you decide to purchase shares of a mix of individual stocks and exchange-traded funds (ETFs) from various sectors and geographic regions.
On a specific day, you execute the lump sum investment by purchasing the selected stocks and ETFs in a single transaction, putting money into that portfolio. From that moment on, your investment is exposed to the fluctuations of the stock market.
Scenario 1: Positive market performance
Over the next few months, the stock market experiences a strong bull market, and the value of your investments increases significantly. The diversified portfolio you invested in outperforms the market, and your initial $50,000 investment grows to $60,000.
Scenario 2: Negative market performance
Conversely, let's say the market experiences a downturn shortly after you invest the $50,000. The value of your investments decreases due to the broader market decline, and your portfolio is now worth $45,000.
In both scenarios, it's essential to remember that when you use a lump sum of money to invest, it means you bear the full impact of market fluctuations. Whether the market performs well or poorly, your investment experiences the effects immediately.
How to invest a lump sum of money
Investing a lump sum of money requires careful planning and consideration of your financial goals, risk tolerance, and time horizon. Here's a step-by-step guide to help you invest a lump sum effectively:
- Assess your financial goals: Determine your investment objectives. Are you investing for retirement, buying a house, funding your children's education, or seeking long-term wealth accumulation? Understanding your goals will help shape your investment strategy.
- Evaluate your risk tolerance: Assess how comfortable you are with risk. Generally, risk and potential returns go hand in hand, so it's crucial to find a balance between risk and reward that aligns with your comfort level.
- Create a diversified investment portfolio: Diversification is a key strategy to reduce risk. Allocate your lump sum across different asset classes, such as stocks, bonds, real estate, and cash, based on your risk tolerance and investment goals.
- Avoid impulsive decisions: Take your time before making any investment decisions. Avoid being influenced by short-term market trends or emotions. Patience and discipline are essential in successful investing.
- Consider low-cost funds: When selecting mutual funds or ETFs, consider low-cost options, as higher fees can eat into your returns over time.
- Rebalance regularly: Periodically review your investment portfolio and rebalance it if necessary. Rebalancing ensures that your asset allocation remains in line with your desired risk level and financial goals.
- Stay informed: Keep yourself updated on financial news and market trends. However, avoid making frequent changes to your portfolio based on short-term market fluctuations.
- Stay committed to your plan: Investing is a long-term endeavour. Stick to your investment plan even during periods of market volatility. Avoid making hasty decisions based on short-term market movements.
- Review and adjust: Periodically review your investment performance and make adjustments if your financial goals or risk tolerance change. Your investment strategy should evolve as your life circumstances do.
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Dollar cost averaging vs lump sum investing
Dollar cost averaging and lump sum investing are two distinct investment strategies, each with its advantages and considerations. Let's explore the differences between them:
Dollar Cost Averaging (DCA)
How it works: With dollar cost averaging, an investor invests a fixed amount of money at regular intervals, regardless of the asset's price. For example, if you decide to invest $500 per month in a particular stock or fund, you will buy more shares when the price is low and fewer shares when the price is high.
Benefits: DCA can help reduce the impact of market volatility. By investing at different price points over time, investors are less affected by short-term market fluctuations and can take advantage of potential market downturns.
Considerations: DCA may result in missing out on the full potential of market gains during bull markets, as the investor leaves some of his money sitting idly even though prices are rising. It requires discipline to stick to the regular investment schedule even during market downturns.
Lump Sum Investing
How it works: Lump sum investing involves putting a significant amount of money into an investment all at once, rather than spreading it out over time. The full investment is exposed to the market immediately.
Benefits: If the market performs well after the investment is made, lump sum investing can result in higher returns compared to dollar-cost averaging. It's a straightforward approach and requires no ongoing effort once the initial investment is made.
Considerations: Investing a large sum of money exposes the investor to the full impact of market fluctuations. If the market declines shortly after the investment, the investor may face short-term losses.
Which one is better: DCA or lump sum?
The decision between dollar-cost averaging and lump sum investing depends on individual circumstances, goals, and risk tolerance:
Dollar-Cost Averaging: DCA is often recommended for individuals who are risk-averse, have uncertain market outlooks, or feel anxious about investing a large sum of money all at once. It provides a disciplined approach to investing and can help smooth out market volatility, as the average price of a position would lower in a bear market.
Lump Sum Investing: Using a lump sum method to invest may be more suitable for investors with a higher risk tolerance and a long-term investment horizon. If an investor believes the market is likely to rise over time, putting the full amount in at once can capture potential gains and save on transaction costs associated with multiple investments.
Ultimately, both strategies have their merits, and the "better" approach varies based on individual preferences and market conditions, though there is some evidence that in certain conditions, lump sum investing tends to outperform DCA. However, the choice doesn’t have to be exclusive, as some investors may even choose to use a combination of both strategies, trying to get the best of both worlds.
Pros and cons of lump sum investing
Here are the pros and cons of lump sum investing you should first consider:
Immediate market exposure: Lump sum investing provides immediate exposure to potential market gains and dividends.
Market timing risk: If the market declines shortly after the investment, the investor may experience short-term losses.
Potential for higher returns: If the market performs well, lump sum investing can result in higher overall returns compared to dollar cost averaging.
Psychological challenges: Most investors feel anxious or hesitant about investing a large sum of money all at once, especially during uncertain market conditions.
Simplicity: It is straightforward and requires no ongoing effort once the initial investment is made.
No cost averaging: With lump sum investing, the investor misses out on the potential benefits of dollar-cost averaging, which can help mitigate market volatility.
Potential cost savings: Investing a lump sum all at once may save on transaction costs compared to making multiple smaller investments over time.
FOMO and regret: Investors may experience fear of missing out (FOMO) if the market rises after the investment, or regret if the market declines.
Long-term outlook: Lump sum investing can be advantageous for long-term investors who believe in the overall growth of the market.
Requires available funds: When investing a lump sum it requires a significant amount of money upfront, which may not be feasible for all investors.
What is the best way to invest a large lump sum?
Before making any large investment, make sure you have a well thought out strategy to balance potential returns with risk management. Diversification across different asset classes is crucial to spread risk and optimise your investment portfolio. One effective approach is to create a diversified portfolio that includes a mix of stocks, bonds, real estate (or REITs), and cash equivalents.
Stocks offer the potential for higher returns but come with higher volatility. Consider investing in individual stocks or diversified stock mutual funds/ETFs to spread risk across different companies and sectors.
Bonds, on the other hand, are generally considered less risky and provide regular interest income. You can invest in government bonds, corporate bonds, or bond ETFs to add stability to your portfolio.
Real estate can be an excellent way to diversify your investments. You can invest in physical properties directly or opt for real estate investment trusts (REITs) that own and manage income-generating properties. Real estate can offer a source of passive income and is seen as an asset to hedge against inflation.
Additionally, keeping a portion of the lump sum in low-risk and highly liquid assets like savings accounts or short-term treasury bills can provide stability and accessibility in case of emergencies.
Which performs better over the long term: DCA or lump sum investing?
The performance of dollar-cost averaging (DCA) versus lump sum investing over the long term is influenced by several factors, such as market conditions, the specific investments made, and the investment time frame. Neither strategy consistently outperforms the other, as each has its advantages and disadvantages.
Dollar-Cost Averaging (DCA) can be beneficial during periods of market volatility since it spreads the investment over time, potentially allowing investors to buy more shares when prices are low. It offers a disciplined approach, reducing the urge to time the market and providing positive outcomes in falling or volatile markets.
On the other hand, investing lump sums of money has the potential to perform better during periods of market growth. Since the entire investment is exposed to market returns immediately, it can lead to higher overall returns compared to DCA when the market rises shortly after the investment.
The effectiveness of each strategy depends on the market's direction. If the market consistently rises, lump sum investing is more likely to produce better results due to immediate exposure to upward movements. Conversely, DCA may prove advantageous during highly volatile or declining markets.
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This does not constitute financial product advice nor a recommendation to invest, it is for informational purposes only. Past performance is not a reliable indicator of future performance. As always, do your own research and consider seeking appropriate financial or taxation advice from a licensed adviser before investing.
Stella is a markets analyst and writer with almost a decade of investing experience. With a Masters in Accounting from the University of Sydney, she specialises in financial statement analysis and financial modelling. Previously, she worked as an equity analyst at Australian finance start-up, Simply Wall St, where she took charge of the market insights newsletter sent out to over a million subscribers. At Stake, Stella has been key to producing the weekly Wrap articles and social media content.