What do large inheritances (or any size monetary inheritance for that matter) and retirement account (IRA/TSP/401K etc.) contributions have to do with one another? On the surface, not that much, but when confronted with planning for either event, they raise the debate about whether it’s best to dollar cost average over a period of time or invest a lump sum all at once. One quick disclaimer: as I’ve written previously, this debate notwithstanding, whenever you receive the government match, you should always contribute to the match level on a monthly basis because that free money is a 100% return on investment (minus the taxes you will eventually pay).
I’ve always been the type of person to Google the movie plot because I get bored easily during a two hour movie, so here’s the bottom line: there is no definitive answer to this question. Financially, investing a lump sum all at once is more likely than not to work out in your favor (but definitely not always as we will see shortly). Emotionally, it is much more likely that dollar cost averaging will minimize regret.
My take: Pick a strategy from the outset, stick with it, and don’t beat yourself up . As is the case with many topics in personal finance, math and emotionally-induced behavior are often at odds with one another, and hindsight makes fools out of all of us some of the time.
Using a baseline 60/40 portfolio (I.e., 60% U.S. stock market allocation in index funds, and 40% U.S. bond market also in bond index funds), Vanguard conducted a study that examined exactly this scenario using many decades worth of data: lump sum versus dollar cost averaging. They found that, on average, immediate investment outperformed systematic longer term dollar cost averaging by 2.39%. Moreover, Vanguard found that 64% of the time lump sum investing outperformed dollar cost averaging in a 6-month window, and it outperformed a whopping 92% of the time in a 36-month dollar cost averaging window. Therefore, the longer the window for dollar cost averaging, the less likely you are to outperform investment of a lump sum.
The Rest (i.e., emotion and behavior)
So, if the amount of out-performance is, on average, greater and the likelihood of out-performance is also substantially greater, why isn’t this necessarily an easy call? Because personal finance is intensely personal, and behavioral considerations also play a huge role in how we look at our investments for retirement.
Our brains are wired in such a way that we dwell on the negative more than the positive, and this likely exists because we evolved and survived by remembering threats in life so as not to get eaten by some prehistoric, massive creature. Roy Baumeister, a professor of psychology at Case Western Reserve University, wrote a widely acclaimed article on this topic in 2001; he found that in study after study on human behavior, it took about three positive experiences to counteract a single negative one. Furthermore, memories are distorted over time, and scientists have demonstrated that negative memories stick with us more than positive ones.
This creates a formidable cocktail when it comes to how a person feels about their investments because regret can cause us to act irrationally going forward with our money. The reason is that it’s not really possible to get three lump sums to overcome the one in any sort of reasonable timeframe (unlike the studies that Blaumeister looked at). Accordingly, the decision sticks with us (“haunts” may not be too dramatic a word in some cases, I suspect). This is especially true if there are no annual do-overs, as is the case with a lump sum from pension payout or an inheritance.
Front-loaded retirement account contributions carry the emotional burden of the work undertaken to save that money, but lump sums from pension payouts carry a lifetime’s worth of sacrifice. Money left to an heir from the death of a loved one perhaps carries the greatest emotional weight (burden?) of all.
If you are a set-it-and-forget-it investor (I.e., you already automatically put 5-10% every month into your TSP, get the government match, and then look at your balance/returns sparingly, if ever, throughout the year), the lump sum method is much less likely to garner buyer’s remorse. Though even then, it is also worth considering whether an emotionally charged event like the death of a loved one leading to an inheritance may put pressure on the most nonchalant of investors. This pressure understandably comes in the form of wanting to honor the memory of that loved one and protect or build upon what they left you.
The math supports lump sum investing over dollar cost averaging, but if you are the type of person to fixate on money matters, you are not likely to care about “the math” if you happen to invest a lump sum and then the market pulls back briefly. I say “briefly” because if your time horizon is long enough, the market will almost certainly correct all timing mistakes when it comes to index funds eventually. I say “eventually” because that correction could take a decade.
One final note: as Ben Carlson remarks in his astute take on this same topic, investing for retirement is ultimately an exercise in regret minimization. We are at all-time market highs right now, so the pitfalls of investing a lump sum – whether it’s an inheritance, pension payout, or front-loading IRA/TSP/401K contributions – might currently strongly outweigh dollar cost averaging. When Ben Carlson wrote his article in May, 2018, the market was lower than it is now, and had yet to go on a powerful 30% run up during 2019. As for 2020, Happy New Year to you all and caveat emptor.