This week, Gail has some suggestions as to what you should do with your bonus — or any other lump sum amount.

Dear Gail,

Please save our marriage! (Kidding.) My wife, Stacy, and I can’t agree on something that I hope you can settle.

She’s going to be getting a bonus in January. We agree that this money should go into the stock market. Our thinking is that we’re both in our early 40s and while we intend to help our two children with college, retirement is our #1 investment priority.

Here’s the issue: I say we should invest Stacy’s entire bonus all at once. She says it’s better to “dollar cost average” and invest 1/12th of the money each month over the next year.

Who’s right?

Mark

Dear Mark,

Do you know what is the #1 cause of marital arguments? Money! I’m glad you and Stacy are apparently able to discuss this rationally. In fact, you’ve already agreed on the most important issue: what her bonus should be invested in. Because equities have historically offered the best inflation-adjusted return for long-term investors such as the two of you, using her bonus to buy a diversified portfolio of stocks is a smart move.

You might think that the stock market sell-off that roughly ran from early 2000 to the end of 2002 would have scared people away from equities. After all, it was the biggest decline we’d seen since the 1930s. But a recent joint study by the Investment Company Institute (ICI) and the Securities Industry Association (SIA) reached a surprising conclusion: more American households own stocks today- either individually or through mutual funds- than in 1999.

In fact, half of all households – some 57 million – now own equities. Contrary to the populist myth that stocks are only for “fat cats,” this survey found that “equity owners represent Middle America.” The average income of stock-owning households is $65,000/year.

Not only is stock ownership up 14 percent since 1999, it increased a whopping 42 percent in the past ten years! Much of the credit for this goes to company-sponsored retirement plans. That’s where most people are first introduced to stocks. According to this survey, “Nearly half of all equity owners began investing in equities by purchasing stock in mutual fund shares through retirement plans at work.”

The important role businesses are playing in helping Americans prepare for retirement is often overlooked. However a report by the Congressional Research Service found that 65 percent of people who work in private industry were covered by a company retirement plan by the end of 2003 — almost 5 percent more than in 1998. Sure, businesses might feel they have to offer this benefit in order to attract good employees, but they deserve credit, as well. After all, adopting, funding, and handling all of the red tape associated with a retirement plan costs money.

Another piece of good news is that more people are taking advantage of the plans they’re offered through work. (Maybe it’s because of all the scary stories about the shaky financial state Social Security it in?) This year’s annual survey by the Profit Sharing/401(k) Council of America found that almost 80 percent of the employees eligible to participate in their company’s retirement plans have balances in their accounts. Company contributions average 4.5 percent of gross pay.

Of course, the negative side to this is that people aren’t saving nearly as much as they ought to be. The average person is contributing a little over 5 percent of his/her paycheck.

Suggestion: If you’re going to get a salary increase next year, why not give your retirement plan a raise, too, and increase the amount you’re contributing?

As for your dilemma, Mark, my excruciatingly diplomatic response is: You are BOTH correct!

The mutual fund firm T. Rowe Price looked at all rolling 3, 5, and 10-year periods going back to 1950. Analyst Jim Tzitzouris compared how much money you’d have if you invested $6,000 in January of each year versus the value of putting the $6,000 into a money market account and investing $500/month from it over the next 12 months. In both cases, Tzitzouris used the S&P 500 Index as a substitute for the stock market.

74 percent of the time and over every single timeframe, investing the entire amount at the start of the year beat the strategy of gradually investing the money over twelve months. When Tzitzouris looked at 10-year rolling periods the lump-sum approach won 79 percent of the time! (Naturally, this did not include the 3-year period from 2000 through 2002. But as I said, that was not the norm.)

According to Tzitzouris, investing your lump sum all at once results in a higher return because “you get greater exposure to the market sooner. More likely than not, in any given year, the stock market will outperform cash.” In other words, when you invest it all in January you have the potential for an extra year of appreciation on the whole amount.

But this is far from the end of the story. While taking the lump sum approach usually results in more money, you pay an emotional price.

Investing a fixed amount of money at regular intervals is called “dollar-cost averaging” because you end up with fewer shares when the price of what you’re buying is high and more shares when it’s low. The net effect is that your average cost/share is somewhere in between the high and the low prices.

Dollar-cost averaging won’t protect you from a loss. What it protects you from is your inescapable human nature!

Look at it this way: Suppose that, on your recommendation, Stacy invests her entire bonus in January 2006. How will she feel (how will [you] feel?!) if in February or March the stock market declines by 10 percent? 15 percent? 20 percent? This isn’t out of the question. Just remember what occurred in 2000.

The answer: pretty awful. In fact, Stacy might feel so badly about her loss that she yanks her money out of the stock market and stuffs it into a bank CD because she can’t stand the pain. As a result, she misses out when the market rebounds. On top of that, the experience might leave her feeling so “burned” by stocks that she never ventures back again and your retirement nest egg ends up being smaller than it could have been. (Less predictable is what she does to you !)

But if most of Stacy’s money were sitting in a money market account as she gradually invested it, she probably wouldn’t be that upset if the stock market declined. In fact, her monthly purchases would enable her to buy more shares thanks to their depressed price. Meanwhile, the rest of her money would be sitting happily unaffected in the money market account.

The point is, dollar cost averaging reduces what the pros call “volatility,” the potential fluctuation in the value of your investment. It prevents you from investing all of your money at the peak of the market and forces you to invest when your gut is screaming “Don’t do it!,” i.e. when there’s been a sell-off. For a long-term investor, “buying low” is one key to profitability.

If you and Stacy can accept the inevitable fluctuation in the value of her investment and remain committed to your long-term goal of retirement, then investing her bonus all at once will probably result in a bigger return. But if market volatility is going to cause Maalox moments and sleepless nights, the gradual approach will serve you better.

As Tzitzouris says, “The important thing is to get in the market. Don’t get too hung up on month-to-month volatility. It’s called a ‘long-term investment strategy’ because it’s long-term.”

Hope this helps,

Gail

If you have a question for Gail Buckner and the Your $ Matters column, send them to yourmoneymatters@gmail.com , along with your name and phone number.