Last week I wrote about lump sum investing vs. dollar-cost averaging, voicing the opinion that in most cases, if a lump sum is available, it’s a better choice in the long run. But how do you invest that lump sum?

It’s great that the financial media has been encouraging young people to start thinking about investing as a part of becoming aware of financial responsibilities and future needs. The general consensus is often to put as much as possible into the stock market for the best chance for long-term growth, and without much further thought, an index mutual fund like VTSMX is the vehicle.

That’s great for a quick start, and it’s better than not doing anything at all, but when these choices are automatic, you’re not really in control of your finances. Walter Updegrave, senior editor of Money Magazine, suggests asking yourself several questions that get to the heart of an investor’s needs and goals. The answers should determine how you should invest your money.

These suggestions are in response to a reader who asked Money Magazine how to invest $300,000 received as part of the sale of a home, assuming these proceeds are not needed to buy a new house. The strive to determine an investor’s philosophy, the true goal of these questions, is the same regardless of the amount to be invested.

The first question is significantly more important than the following two, but as you’ll see, questions two and three will have a significant effect on the success of question one.

Question 1: What am I investing this money for? Most people don’t think about their goals. The object, they may believe, is to just keep increasing their net worth. Money in a bank is great to have, but there’s no point to money unless it is being used for something, either now or in the future. A high net worth is not a goal, it’s just an intermediary step to achieving a real goal. Having investments worth $1 million (or $10 million, or $10 billion) is merely a milestone, not a destination.

Updegrave suggests determining the goal for just the immediate funds you have available, but I suggest looking broader if you haven’t already? What do you want to do with that money? Besides having enough to improve the quality of your life, do you want to improve life for the poor? Do you want to foster a wider appreciation for the arts? Do you want to own a baseball franchise? Will your money go to work building a school?

Once you’ve decided on a major goal or two, you can have a better sense of what your goal is for the amount you have available to invest today. Perhaps you can use it to get started on one of these goals, but perhaps you need a car to get around or you want to pay for your children’s college education.

Question 2: What investments do I need to achieve my goal? This is a more difficult question for the investing novice. Updegrave suggests keeping it simple by building your portfolio from just two index funds, one containing stocks and the other containing bonds. Adjust the allocation between asset types to suit your growth needs and risk tolerances.

You should have a time horizon in mind to help you determine your allocation. Without a time horizon, you will not know how much risk you can tolerate. Even the best plans often fail due to unforeseen needs, so your investments should be flexible, as well.

Question 3: What am I paying for my investments? Index funds simply match market index benchmarks like the S&P 500, so you would expect all index funds in the same category to provide you with the same gains each year. It’s not quite that simple; management fees eat into those returns, causing some funds to consistently perform better than others. The same holds true for managed (non-index) mutual funds. The solution is simple: given similar funds, choose the fund with the lowest fees.

Questions to ask yourself when investing, Walter Updegrave, Money Magazine, June 22, 2010

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Pop writes about the intersection of our lives and economics at Pop Economics. There, you can find biweekly posts on everything from how your behavior affects your personal finance decisions to what the Fed’s most recent move means to you — not to mention some killer pop art. He recently wrote: Resistance is futile: Why buy-and-hold beats value investing.

The fact of the matter is: Most of us dollar-cost average when we invest because we have to. We get paid biweekly or monthly, and we invest our savings as soon as we receive it. We don’t have gigantic piles of money sitting around that we must choose to invest in a lump or over time.

But because dollar-cost averaging is personal finance 101, you’re going to find arguments as to why it’s the “best” way to invest anyway all over the place.

The refrain goes something like this: Let’s say that rather than put all your money into a mutual fund at once, you invest a set amount, say $1,000 per month, over time. When the fund is at $100 per share, you’ll buy 10 shares. When it’s at $150, you’ll only buy 7 or so shares. That way, you force yourself to buy more shares when they’re cheap and fewer when they’re expensive! You’ll see that argument at lots of reputable sites.

The problem with that explanation is that it suggests if you did have the choice between investing over time or all at once, you should invest over time. That doesn’t make sense, and here’s why.

1. Dollar-cost averaging works in reverse when you retire anyway.

Just as you might put $1,000 per month into stocks when you’re in the wealth accumulation stage of your life, you’re going to withdraw, say, $10,000 per month from your portfolio when you retire. And yes, that means you’ll be selling more shares when they’re cheap and fewer when they’re expensive — just the opposite of the supposed benefits dollar-cost averaging gave you when you started!

2. When you rebalance your assets as you age, it’s unrealistic to keep the strategy up.

Most of us invest a lot in stocks when we’re young and less in stocks (and more in bonds) as we age. Conventional wisdom holds that you should have, say, 90% in stocks and 10% in bonds when you’re in your 20s, but closer to 40% in stocks near retirement. But how do you get from one allocation to the other?

Dollar-cost averaging would seemingly dictate that you should slowly re-balance your portfolio as you age every month. In other words, when you hit, say, age 30, you’d sell a bit of your stock portfolio and buy a little bit of bonds each month as you got older. Aside from falling into the trap described in point one, how many of us could keep that up? And if we could, the transactional costs associated with the process, such as commissions from trading ETFs, would eat into our savings.

3. If you do have a lump-sum to invest, and choose to dollar-cost average, you’re throwing your asset allocation off, big time.

Pretend you’re in your 30s, have $100,000 saved so far in a 80/20 stock/bond mix, and come into a $100,000 inheritance. Hearing of the merits of the dollar-cost average approach, you choose to trickle the money into the stock market over time.

Well guess what? On day one, your asset allocation would be 40% stocks, 10% bonds, and 50% cash. Not exactly the aggressive asset allocation you intended, right? Just because you mentally put the $100,000 inheritance into a pile of money separate from your retirement savings doesn’t make it actually so.

And if you believe the stock market generally rises over long periods of time. The short-term volatility you’re trying to smooth out doesn’t matter anyway. The best time to invest will always be ASAP.

Something dollar-cost averaging is good at

At the end of the day, the completely rational individual would choose to make a lump-sum investment instead of to dollar-cost average. But exactly zero of us are completely rational. So there’s one big reason I can see someone choosing the DCA route, despite the arguments against.

In two words: “Loss aversion.” Humans fear losses more than they love gains. This tendency is well-documented by economists. So if you invested all $100,000 in a lump sum and the market dropped 5% the next day, you’d leave with an emotional scar. But alternately, if you began a DCA program and the market rocketed 5% the next day, you wouldn’t be nearly as sad.

That’s not rational — but it is the way we think. If you can’t get over that hump, you might decide that the cost of dollar-cost averaging is worth your emotional well-being. Just don’t pretend it’s making you money.

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