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What to Do With a Lump Sum in Retirement

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It’s a common problem in or near retirement: A relative passes away and leaves you an inheritance. Or you receive a lump sum pension payout. Or you sell the big family home and downsize.

In each case you suddenly have a large sum of cash on your hands….

What should you do with the unexpected windfall? Do you hoard it, or invest it? And, if you’re going to invest it, exactly how and when do you put that money to work?

Do you buy more of your existing holdings, or do you take a chance on something new? And, do you move into the market immediately, or do you make your purchases over time?

Let’s take look at the issues behind each of those questions….

Asset Allocation

The first question when receiving a large sum near retirement is whether and how it changes your overall financial picture. Is it actually enough money that it changes your risk tolerance or lets you target opportunities that you couldn’t before? Or is it really just a footnote on your existing financial plan — money you should probably just fold into your existing assets?

The issue at stake is your asset allocation. What was it before this windfall, and what are the reasons, if any, for it to change?

Does the recent event justify a new risk profile? If not, then you should probably just restore your former asset allocation ASAP. By contrast, holding the windfall in cash, or buying into a new asset class with it, would likely change the allocation of your portfolio. And you could wind up more conservatively or aggressively invested than you had intended to be….

My Conservative Play

However, as my own experience demonstrates, making these decisions in practice is much harder than just writing or reading about them in the abstract. For example, about three years ago I unexpectedly received a low-6-digit inheritance. After some thought about our early-retired situation, I decided to simply hold the cash, rather than invest it in our existing holdings. That decreased my percentage of stocks overall and made my asset allocation more conservative for several years.

Why did I do this? Here was my thinking: One way or another, I would need cash in the next several years for our retirement living expenses. Meanwhile, the Dow was setting new highs, and the age of the bull market was well past the historical average. I knew that the odds of a serious downturn were increasing. (Though it still hasn’t happened.)

I also knew, as explained in my second book, that sequence of returns risk was one of the greatest threats to my early retirement. Yes, I had saved enough for financial independence, in most scenarios. But, if the market plunged near the start of our retirement, the regular withdrawals we required for living expenses could so damage our assets that they’d never recover….

Simply holding that inherited cash could cover our living expenses for several more years, and, by shielding our invested assets from withdrawals, buy me that much more certainty in my early retirement. So that’s the path I chose. And I don’t regret it.

Yes, I probably left some potential investment earnings on the table, because my asset allocation has been a little more conservative in the continuing bull market. But, here we are now on the cusp of our 60’s, sleeping well and with our early retirement nest egg intact. I have no complaints.

Dollar-Cost-Averaging

But, suppose you decide you have no immediate need for your windfall, and that it shouldn’t change your risk tolerance or asset allocation. So, you’re going to use it to buy into your existing holdings, in the same proportions. Do you make that investment immediately, or do you wait, or do you invest gradually over time?

That latter approach is known as “dollar-cost-averaging” (DCA) and it’s often the conventional wisdom you read in the financial press. And how does dollar-cost-averaging work, exactly? Well, for example, if you had $120K to invest and wanted to dollar-cost-average over a year, you would invest $10K each month. The idea is that, as the market fluctuates, your dollars buy more shares when prices are down and shares are cheap, plus you reduce your risk of a large unrealized loss if the market drops suddenly.

But, when it comes to the hard data predicting financial success, the conventional wisdom for dollar-cost-averaging is wrong. That’s because both extensive research, and common sense, dictate that dollar-cost-averaging will, in addition to reducing your risk, also reduce your returns, on average.

Why is that? Because when you dollar-cost-average, you are essentially betting that the market will go down in the future. You are assuming that, by waiting, you’ll get a better value for your investing dollars.

But what have markets always done over the long haul? They’ve gone up. In his take on dollar-cost-averaging, Jim Collins reports that between 1970 and 2013, the market was up 33 out of 43 years, or 77% of the time.

So, on average, that safer dollar-cost-averaging bet is also a losing bet….

Lump-Sum Investing

A study by Vanguard found that a lump-sum investing approach (the opposite of dollar-cost-averaging) outperformed a DCA approach about two-thirds of the time. It concluded that “…the prudent action is investing the lump sum immediately to gain exposure to the markets as soon as possible.” But it added that “…if the investor is primarily concerned with minimizing downside risk and potential feelings of regret (resulting from lump-sum investing immediately before a market downturn), then DCA may be of use.”

At Oblivious Investor, Mike Piper writes that during the time you are dollar-cost-averaging, your asset allocation will be off-target due to the extra cash you are holding. And that’s a problem: If you wanted to be at a certain asset allocation because it’s the most suitable to your own personal risk/reward profile, then why would you want to wait? Why not invest that cash fully and reach that target allocation immediately?

On the other hand, if you actually feel better having that cash on hand, then maybe your target allocation is too aggressive in the first place!

Finally, if you are persuaded to invest a lump sum in one shot, beware your own investing experience and motivation. If your move is based on an understanding of the probability of the market going up over time, then you have a good chance of being happy with the outcome, whether or not it’s immediately profitable. But if your move is based on a “hot pick,” or a gut feeling about near-term market momentum, the results could be disastrous.

My Solution

My own personal experience with dollar-cost-averaging versus lump-sum investing during the 2008-2009 Great Recession is instructive:

I had some extra cash on hand near the start of that downturn, in the summer of 2008, plus I needed to rebalance due to the dramatic fall in stocks. So I set about methodically dollar-cost-averaging, adding a few thousand dollars to my stock funds every month. I continued that way for almost a year, as the market spiraled downward….

But it wasn’t enough. I ran out of cash before the market reached bottom in early 2009. And the bounce back in later years dwarfed whatever savings I had achieved from buying a few shares lower.

And the entire process was time consuming to implement. Every month I had to make a purchase. And that resulted in many small transactions in my taxable accounts, which complicated future tax calculations.

In the end, the benefits to me of dollar-cost-averaging were negligible. I wished I had put the lump sum to work immediately, according to my target asset allocation. At approximately 50/50 stocks/bonds that allocation was already conservative enough to blunt most of the risk.

My philosophy since then has been to invest lump sums sooner than later. That said, though I’ve been investing for a long time, I still can’t ignore the emotional factors around spending large sums on a single day. Like most humans, I can’t help but worry about what the market will do the next day.

So, on most occasions in later years when I’ve had larger sums to put into play, I’ve usually broken purchases into two or three transactions over a period of a few months. That’s been a good compromise, for me, between the high probability bet of investing sooner, and the immediate downside risk. The theoretical return I give up by investing over a few months is minimal. And moving a little slower has helped me confidently tread the path between the risk of being in the market, versus the risk of being out of the market….

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