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How to invest a lump sum

Imagine it: you’ve come into a fairly substantial sum of money. You’ve cleared your debts, and figure you’d now like to invest the money in stocks.

What’s the best way to invest the money going forward? All at once, or by putting a percentage amount of the lump sum into your chosen stocks each month?

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In this example, our imaginary investor has an investment vehicle, like a Stocks and Shares ISA, and a portfolio of stocks they want to own. We are going to examine if it is better to put all of the money in at once, or to feed it in over time.

Pound cost averaging

This phrase might be familiar. Pound cost averaging is the process of buying a stock at regular intervals, say monthly. For example, an investor with a lump sum of £100,000 may choose to invest £8,333 a month over a year.

The benefit of this approach is that as the stock price fluctuates up and down, the investor is likely to buy at both the high and low points, meaning that the average price paid will even out over time. The idea is that the investor will not lose out if the market suddenly drops after investing the lump sum.

Pound cost averaging sounds good then. But there are a few drawbacks.

By holding back the money and staggering the investments, your asset allocation will have changed. For example, a £100,000 portfolio may go from having 80% of your investment in stocks and 20% in bonds, to 40% stocks, 10% bonds, and 50% cash, while you hold back money to invest over the coming months.

As we know, over the longer-term stocks tend to return more money to investors than cash. Therefore, the possibility of half your portfolio not significantly increasing in value is probably not an ideal situation.

This brings me to the other negative with pound cost averaging – that markets tend to go up more than they go down.

Let’s examine the alternative.

Invest it all at once

To the prudent investor, investing a lump sum at once will sound scary. In a bear market, there will be concerns that stock prices will only fall further. In a strong bull market, people will be predicting the end-times. Either outcome would be less than ideal.

There are some, like JL Collins, the author of The Simple Path to Wealth, who think it is best to invest a lump sum at once. He argues that by pound cost averaging (or dollar cost averaging, to him) you are betting that the market will go down. History, however, has shown that over longer periods, the stock market tends to go up.

Your investment will possibly earn dividends too, which could be worth more than the interest that most cash savings accounts are offering at the moment.

Each investor’s situation is different, and risk tolerance is down to personal preference. But when it comes to investing a lump sum, I think I’d take the view that it is probably better to invest it all at once.

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T Sligo has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.