Congratulations, you’ve received a chunk of change! Maybe it’s an inheritance, signing bonus, proceeds from a business sale, or similar windfall – or maybe you’ve been sitting on a stash of cash for a while.
You’ve decided to put the money to work by investing it in the market … but you hesitate. The market has seemed wonky of late; is this a good or bad time to get started? When you do take the plunge, should you dive in with the entire lump sum or ease in cautiously over time with dollar-cost averaging? What is the right investment approach?
There are several reasons why the most rational approach to this common conundrum is as follows: Regardless of near-term market conditions, get into the market with as many investment dollars as you have available, as soon as they are available. Spread the market risks around by diversifying your holdings.
Going the Distance in the Market
A recent article in The New York Times, Hesitating on the High Board of Investing, offers a good summary of why we typically prefer this all-in, lump sum approach. The data shows that, properly implemented, it’s expected to yield better results.
This has to do with near-term versus long-term market behavior. When viewed up close, the near-term market is in a near-permanent state of “wonk,” with no signs to tell us what’s coming next. This makes it nothing more than luck whether you’re entering the market at the best of times, worst of times or (most likely) somewhere in between.
But it almost doesn’t matter because, when viewed from a comfortable distance, the market’s long-term direction has been onward and upward.
What does this mean for you? Whether the current market is rising or falling, the sooner you jump in with all of your available investment dollars, the sooner you can expect to capture more market wealth according to your goals.
(By “investment dollars,” by the way, we mean the portion you have determined should be put to long-term work in the stock market, versus the portion that needs to be protected from market vagaries or that has been earmarked for near-term spending.)
Empirical Evidence for This Investment Approach
The aforementioned New York Times piece references a couple of analyses substantiating the expected long-term benefits of lump-sum investing.
- A Vanguard paper looked at the results of dollar-cost averaging versus lump-sum investing in the U.S., the U.K. and Australia for 10-year rolling periods from 1926–2011. Its authors concluded, “On average, we find that an [lump-sum investing] approach has outperformed a [dollar-cost-averaging] approach approximately two-thirds of the time.”
- The article also cites an analysis by Bernstein Global Research, which reached similar conclusions. Based on this research, the article indicated that “the penalty for investing gradually [dollar-cost averaging] … was 4.1 percentage points.”
Pictures in Place of Words
To convert these important concepts into powerful illustrations, here is what happens if you fret about precisely when or how much of your investable assets to put into the market:
And here is what the slow, steady market has been doing all the while:
When an All-In Approach May Underwhelm
Theory is all well and good. But there also are reasons why this most rational approach in theory may not be the most rational approach for you.
In real life, I often hear something like this from hesitant investors: “Greg, the market has had a nice run recently. Maybe I should wait for a pullback before getting in.”
Conversely, whenever the market is bleeding negative numbers, many decide to wait for signs of a recovery before getting in – or, worse, they panic and get out if they’re already there.
In short, managing your behavioral weaknesses is at least as important as managing your portfolio. For example, if you were invested in the market as we entered the financial crisis of 2007–2008, were you able to stay put and benefit from the resulting recovery? Or did you lose your nerve and go to cash?
If you cashed in, a lump-sum approach may not be for you after all. Moving into the market more gradually with dollar-cost averaging may help you stick with your plan when the going gets tough, in which case, you may end up better off financially than if you stretch for, but fail to achieve empirical nirvana. Plus, you may have fewer sleepless nights during the troublesome times. For anyone who has ever been a parent, we know how valuable that can be!
So, dive head first or dip your toe in the market? If you’re unsure, a conversation with an advisor familiar with both the empirical and emotional issues involved can pay for itself, helping you look before you leap, and make a choice that is logical for you – in theory and in practice. Let us know if we can help with that.
For more information or to set up a consultation, contact Pathway Financial Planning at 248-567-2160 or email email@example.com.