How Should You Invest Your Bonus? Periodically or in One Lump Sum?
Let’s say you just received a $12,000 bonus from your work.
You don’t want to just spend all of your bonus on Popeyes chicken sandwiches.
Simple math tells us that $12,000 at $4 per sandwich buys you 3,000 sandwiches.
If you need 3000 chicken sandwiches you may have a problem.
Instead of splurging on Popeyes chicken sandwiches, you decide to do the financially wise thing and buy shares in promising businesses by purchasing a basket of stocks.
Now the question is:
Should you invest your bonus of $12,000 all at once to purchase your stocks?
Should you divide your investment into equal installments which you invest after equal intervals of time?
For example, investing $1,000 at the beginning of every month for the next 12 months.
This latter method is often called Dollar Cost Averaging.
Invest Your Bonus: Lump Sum vs. Periodic Investing
Lump-sum investing is superior to periodic investing when the market is trending upward.
This is because when an asset is appreciating, the earlier you have ownership of it the more money you’re going to make.
On the other hand, when the market is trending downward the periodic investment approach is superior.
This is because with periodic investing you’re able to buy shares at increasingly lower prices which means the number of shares you end up with after investing will be higher.
Accordingly, to answer the question of whether the lump sum or periodic approach is going to be more advantageous one must be able to predict whether the market is going to be upward-trending or downward trending during the investing period.
This requires market timing which is pretty much impossible to do reliably.
What we can do, however, is to look at the historical results of each approach.
Historical Results of Lump Sum Investing and Periodic Investing
Vanguard did a study of the two approaches using a rolling 12-month period and concluded that between the years of 1926 and 2015 if the investor was investing 100% in equities, the lump sum investment approach was superior to the periodic approach about two-thirds of the time.
The difference between the two approaches was an average of 2.4% in the United States in favor of lump-sum investing.
So this means that lump sum investing is objectively better than periodically investing, right?
The average return can often be misleading because it doesn’t tell us about volatility.
Put differently, it doesn’t say anything about risk.
In a game of Russian Roulette, a bullet is loaded into a chamber in a revolver, the revolver is spun and then the trigger is pulled. The expected result of this action is that the gun will not fire since there is only one bullet in the gun and 6 different bullet chambers.
However, I think we can all agree that playing Russian Roulette is pretty dumb despite the statistically expected outcome.
This is because the expected outcome completely ignores the high cost of the unlikely outcome.
Luckily with investing the stakes aren’t as dire as Russian Roulette but you get the idea.
In order to truly evaluate the merits of a particular strategy, you have to look at both return and risk.
Understanding The Risk of Lump Sum Investing
While It’s true that the lump-sum investment approach has historically yielded better results two-thirds of the time, with the lump-sum investment approach you run the risk of investing at exactly the wrong time.
For example, if you bought the market at the beginning of 2008 with a lump sum, by the end of the year you would have lost 38% of your investment, compared to 26% if you used the periodic investing technique.
I did a few calculations to illustrate this point. See the table below.
|Lump Sum||periodic Over 12 Months||Lump Sum||periodic Over 12 Months|
|S&P 500 Returns||$12,000||$1000/month||$480,000||$40000/month|
|Dollar Amount Difference between losses||$1,409||$56,349|
When the amount invested was $12,000, the difference between lump sum and periodic investing in 2008 was $1,409 in favor of periodic investing.
When the amount of investment is $480,000, the difference between the two approaches was $56,349 in favor of periodic investing.
Afterward, if the investment is held for the next 11 years, until the end of 2019, the difference of $1,409 translates to a difference in return of $4,942 whereas the difference of return of $56,349 translates to a difference of $197,686!
So what I’m trying to say by all this is: yes, statistically the lump sum approach yields favorable results compared to periodic investment.
However, as individuals, we don’t experience the average we have individual experiences which may or may not be close to the average.
Accordingly, we have to consider the downside scenario for any course of action we take and whether we’d be OK with it even if its probability was relatively low.
So if your priority is to maximize returns, statistically your best bet is the lump sum approach.
On the other hand, if your priority is capital preservation and minimizing regret, then the periodic investment approach seems like the better alternative.
I would also add that the longer you space out the investment period, on average, the worse your performance is going to be compared with the lump sum method.
In the Vanguard study, using 36-month intervals the lump sum approach beat periodic investing more than 90 percent of the time. The results were much closer over six-month time frames.
Some factors that would sway me to use the periodic investment method include:
- If I’m investing a large sum of money. The risk of investing at exactly the wrong time becomes more pronounced with a larger sum of money so I may opt for the periodic approach in this case.
- If my time horizon was relatively short in which case if I did invest at exactly the wrong time my investments would not have enough time to recover before I needed to cash out.
So those were my two cents on whether to lump sum investment or periodically invest.
As with many things in finance, there is no definite right answer. You have to adapt your approach based on your particular circumstances and hopefully, this article helps you to do just that.
The information provided in Practical Islamic Finance articles and accompanying material is for informational purposes only. It should not be considered legal or financial advice.
Practical Islamic Finance does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any investment decision without first consulting his or her own financial advisor and conducting his or her own research and due diligence.