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What should I do with my tax refund?

Figuring out when to invest in the stock market can be challenging. How do you avoid regret?
By Wei-Yin Hu, Ph.D., Vice President, Financial Research

You may be one of many people receiving income tax refunds this year and asking, “what should I do with my tax refund?” An unexpected windfall is good news, though it might also mean that you should adjust your tax withholdings to keep more of your money throughout the year. It could be even better news if you can afford to invest that money in a diversified portfolio to save for your retirement.

Whether you have a sum of money to invest due to a tax refund or some other source, you might feel unsure about when to invest in the stock market – do you invest it right away in one lump sum, or spread it out over a period of weeks or even months?

If you’re a purely rational investor, it makes sense to put the money to work right away. That’s our typical recommendation. Markets historically go up over time, so every month you’re out of the market, you’re potentially missing out on growth. And you’ll be smart enough to know that you can’t time the market to know when a temporary dip will allow you to invest at lower prices.

But for the rest of us, as human beings with feelings and emotions, we might worry about looking back with regrets. What if the market falls the day after we invested? After all, there’s about a 50-50 chance that any single day could turn out to be a “good” or “bad” time to invest. While you may know this before you invest, that fear of regretting our decisions can take on a lot of emotional weight after the fact. So what should we do with the tax return money and how do we avoid looking back with regret? Here are two suggestions that could help:

Lump-sum investment

Pledge to avoid looking at the value or performance of that lump-sum investment for at least a year. A watched pot never boils, as the saying goes. That is, if you are focused on waiting for something to develop, it may seem as if it will never happen. Think of the lump-sum approach as something more akin to planting bulbs in the autumn and knowing you won’t see the results until spring. If you give your investment time and space to grow, you’ll be less likely to narrow in on the day-to-day price movements – and avoid the stress that can come with that!

Dollar-cost averaging

Consider using “dollar-cost averaging” to invest. Dollar-cost averaging describes a strategy for investing money in smaller pieces, spread out over time. With this approach, you are less likely to focus on just one moment in time when you invested. Some moments may turn out to be good in hindsight, and some may be less so. But investing over time allows you to reduce the impact of any market swings that could happen on a single day.

If you do this, consider spreading out your investment over a period of days or weeks, not several months. If you delay for too long, you’ll be leaving money sitting idle in cash, earning virtually zero return instead of earning the long-term return of a diversified portfolio. Note that dollar-cost averaging is not expected to give you better investment performance. It’s merely a tool to help overcome our very human tendency to feel regret in hindsight.

Combination of investment strategies

You might also consider blending the two alternatives: Take half of your tax refund lump sum and invest it right away. Then spread out the other half over a few days or weeks. This way, a good part of your money goes to work right away, but you still get some psychological comfort from spreading out your investment over time.

A tale of two investors

Let’s compare what would happen if two investors each had a tax refund of $2,000 on March 31, 2020. What should they do with their tax refund?

Person A chooses lump-sum investing and invests their whole tax refund of $2,000 on March 31. Person B chooses dollar-cost averaging and invests $500 on March 31, and $500 on each of the following three trading days.

Who feels better? Given that markets went down on April 1, with the S&P 500 losing 4% in a day, Person A might feel significant regret. Person B got the benefit of buying stocks at lower prices on the subsequent days. But things could have easily been different, by shifting just one day to April 1. Then Person A would have felt pretty good about buying at a time when prices were low, while Person B bought into a rising market.

Whichever approach you opt for, the simple truth is that there are no guarantees. You can’t time the market. So maybe you are happy to jump in with both feet, or you may feel more comfortable averaging out your investments over a few days or weeks. The key is to try not to react emotionally and to remember that you’re in it for the long haul and investing in your future. And, of course, an Edelman Financial Engines planner is just a phone call away if you want to discuss your options further with a fiduciary financial advisor.

chart of two investor scenarios; lump sum and over time

This is a hypothetical illustration and is not representative of the past or future results of any specific investment vehicle.

Dollar-cost averaging does not assure a profit or protect against a loss in a declining market. For the strategy to be effective, you must continue to purchase shares in both up and down markets. As such, an investor needs to consider his/her financial ability to continuously invest through periods of low price levels.

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