When it comes to investing a windfall such as an inheritance or retirement account rollover (IRA, 401K, etc..) you’ll likely find a large number of different options being discussed in the financial media. But which one of these many approaches is best for you?
Dollar cost averaging, or investing the new money a little at a time, is a fairly common approach. The reason: By dribbling your money into the market, you’ll invest some at lower prices and some at higher prices, averaging out the risk over time. So, for example, if you have $250,000 to invest, you’d move $20,833 each month ($250,000 divided by twelve) from a savings account to a portfolio of stocks and bonds.
However, this ignores the fact that the longer it takes to obtain the mix of stocks and bonds that is consistent with your goals and risk tolerance, the longer it will be before your money is invested the way it should be.
Another strategy is to decide on an allocation of stocks and bonds that will help you meet your financial goals, and then invest the total amount based on that allocation. So, for example, you might invest 70% of your $250,000 in stocks ($175,000) and 30% in bonds ($75,000). This will allow you to reach your target allocation quicker (because the money isn’t sitting in your savings account for a year).
Which approach is better? It depends on your individual goals, time horizon and tolerance for unknown risk. The reality is that no one knows what stock or bond prices will do in the future, especially in the short term.
So, if you’re unsure how to invest your windfall, or you just can’t bring yourself to invest all of your money at once, why not talk to your advisor about combining approaches? For example, you either might limit the period over which you gradually invest, doing it over three or six months instead of twelve or change the frequency, doing it quarterly instead of monthly.