The Best Way to Invest a Lump Sum

You probably have a lot of experience with investing small amounts. But what should you do when you get a big chunk of money all at once?

For most people, money doesn't come in big lumps. When you get a regular paycheck once or twice a month, the easiest way to save is a little at a time. Whether you save $50 each month or $500, putting together a regular automatic investment plan is simple to do.

Dealing with windfalls
But every once in a while, you'll have larger amounts of money to invest. You might get a large bonus at the end of the year, or a big tax refund check from the IRS. Your employer might have you roll over your retirement plan all at once, or you might get an inheritance or life insurance payout.

The first thing you should remember when this happens is not to panic. You don't have to take decisive action the first minute that big check is in your hands. Take some time to get your bearings. Do some research to see if the investments you already own are suitable for this new money as well, or whether you'll want to find new ways to invest.

Dollar-cost averaging
Once you know what investments you want to buy, the big question is when you should pull the trigger. One method -- dollar-cost averaging -- involves dividing your lump sum into several pieces and then investing those smaller amounts over a longer period of time.

Dollar-cost averaging has some appealing things in its favor. Because you spend the same dollar amount each time you invest, you buy more shares when prices are low. So when the market is falling or moving sideways, you'll often end up with more total shares with a dollar-cost averaging plan than by investing all your money at once.

The problem, however, is that stocks prices tend to go up more than they go down. So as some academic studies have shown, if prices follow their general trend upward, you'll often end up with fewer shares at the end of your dollar-cost averaging plan.

How it works in the real world
Consider a simple example. Say two investors had $10,000 to invest at the beginning of 2007. One invested the whole amount in January, while the other split it into two parts and invested half in January and half in July.

Here are the results with various stocks:

As you'd expect, dollar-cost averaging gave great results for stocks that moved down during the year. But on stocks that rose in price between the two purchases, investing all at once was the right move.

What should you do?
Obviously, you can't predict whether your stocks will rise or fall in the coming months. In general, if you have confidence that you're making good investments, investing all your money at once will yield better results if you're right.

On the other hand, some psychological factors also come into play. If you invest everything upfront and then the market tanks, will you panic and sell what you intended to be a long-term investment? If so, then dollar-cost averaging may make you more comfortable with your investments, letting you ride out a downturn at the cost of missing out on some upside if stocks rise.

For more on how to retire in style, read about:

• Why you shouldn't treat your 401(k) like an ATM.
• What it takes to get ready to retire.
• Some simple steps to help you invest smarter.