When it comes to investing a windfall -- or any large sum, such as a 401(k) or IRA rollover -- advisers and the financial press often recommend dollar-cost averaging, or investing the new money a little at a time. The rationale is that you're taking on less risk by tiptoeing into the market rather than plunging in all at once.
So the standard advice in your case would be to put the $250,000 in a savings account or money-market fund initially, and then over the course of, say, a year invest $20,833 each month ($250,000 divided by 12) in a portfolio of stocks and bonds.
But like many other supposed nuggets of investing wisdom, this one doesn't stand up to close scrutiny.
In fact, the more sensible strategy is to settle on a mix of stocks and bonds that jibes with your financial goals, and then invest the whole sum based on that mix. So, for example, if you decide based on your risk tolerance and the length of time your money will remain invested, that a portfolio of 70% stocks and 30% bonds is appropriate for you then you should allocate 70%, or $175,000 to stocks and 30%, or $75,000 to bonds.
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To understand why this approach makes more sense, let's take a closer look at what happens if you invest gradually, or dollar-cost average, instead of invest the entire $250,000 in 70% stocks and 30% bonds.
With dollar-cost averaging, you'll start out with an asset allocation that's 100% cash. After three months of shifting money into stocks and bonds, you'll have $43,750 in stocks, $18,750 in bonds and $187,500 still in cash, or a portfolio of 17.5% stocks, 7.5% bond and 75% cash. After six months, your mix will be 35% stocks, 15% bonds and 50% cash. And at the end of nine months, you'll have 52.5% in stocks, 22.5% in bonds and 25% in cash.
Only at the end of the year will you arrive at your target allocation of 70% stocks and 30% bonds. (To keep things simple, I haven't factored in any investment earnings on stocks, bonds or the cash holdings.)
In short, you'll actually go through a series of asset mixes that are more conservative than the mix you've decided is right for you. Or, to put it another way, for an entire year you'll be investing more conservatively (much more conservatively early on) than you should based on your risk tolerance, time horizon and financial goals.
Now, I'm sure that many readers are now saying, "Yes, but if the stock market goes down and bond prices fall due to rising interest rates during that time, I'll take a bigger hit by going immediately to my target allocation than I would by dollar-cost averaging to it over time."
That's true. But it's also true that you won't do as well going in gradually if stocks and bonds perform well.
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The reality is that no one knows what stock or bond prices are going to do, especially in the short-term. Which is why savvy investors divide their assets between stocks and bonds based on their financial goals and appetite for risk in the first place. Asset allocation is a way to get some short-term protection against market setbacks while still allowing you to get the returns you need long term. But by dollar-cost averaging into your target portfolio rather than going to it immediately, you're undermining your investment strategy -- or at least putting off getting to it
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