Investors lucky enough to be sitting on a hoard of cash to invest now are facing a tough decision: Plunk down the entire sum or dollar-cost average, placing scheduled investments over a period?
Research from Vanguard, analyzing data in the U.S., U.K. and Australia, indicates that in upward-trending markets, it is always best to invest in one fell swoop. The giant fund provider’s researchers found that lump-sum investing beat dollar-cost averaging strategies—where investments are made over a scheduled period—on average two out of three times, with a 60/40 portfolio mix of stocks and bonds for U.S. investors returning on average 2.3% more over 12 months.
While that outperformance might seem small, compounded over 20 or 30 years, the difference becomes substantial.
It’s important to note that Vanguard’s figures represent averages and unpredictable markets make outcomes for investors, well, unpredictable.
The S&P 500 index
fell more than 10% in February and has been struggling to recover, trading flat for the year at 2,670.58. Meanwhile, the longevity of this bull market—in its ninth year—has been stoking fears that the party that has been marked by repeated records may be coming to an end.
Adhering to the advice of lump-sum investing that is backed by research, however, can have its own pitfalls. Mainly, human emotions can lead to making mistakes due to cognitive biases.
Blair DuQuesnay, principal and chief investment officer at ThirtyNorth Investment LLC, New Orleans-based advisory firm, said a dollop of practicality should be applied.
“There is a lot of evidence that lump-sum investing is the best solution, but we are all humans and our behavioral biases may end up causing us heartache and eventual mistakes,” DuQuesnay said.
“Which is why we take into account the risk tolerance of the client, the amount that needs to be invested and costs associated with trading. The more you trade, the higher the cost,” she said.
DuQuesnay, whose clients are typically high-net worth individuals said that her firm has a strategy to deal with situations when clients have a windfall sum to invest and it can differ depending on the amount to be invested.
For example, someone investing $1 million in a balanced portfolio in the summer of 2007 would have watched it lose more than a third of its value over the following 20 months. While definitely a stroke of bad luck for someone in this situations, investors should remember that statistically it is a lot more likely that investors come to money when markets aren’t at a peak.
Minimizing potential regrets is something that keeps investors from making mistakes, such as selling at the wrong time.
“With a $1 million windfall we would suggest to divide it into three chunks to invest one immediately and the rest with a 30-day interval. It wouldn’t make sense to do it in smaller chunks because of trading costs, but by dividing it into three parts investors will feel good whether the market immediately falls or rises,” she said.
In other words, dollar-cost averaging is best applied to address immediate emotions rather than reducing risk or improving returns over the long term.
Smaller sums, however, should be invested all at once, according to DuQuesnay.
“Investors with anything below $100,000 and with a longer-term horizon would still benefit from investing all at once,” she advised.
As to elevated valuations in the U.S. stock market, the best solution is still to diversify across asset classes and geographies, according to DuQuesnay.
Whichever strategy that an investor decides to use, maintaining a long-term strategy is ideal because trying to discern the best time to get in and out of the market can be a mistake.
“We should not try to time the market, but choose and then stick with a strategy that we can live with,” DuQuesnay said.
Ben Carlson, director of institutional asset management at Ritholtz Wealth Management in a Bloomberg column earlier this month put it this way: “Investors need to ask themselves what they would regret more—missing out on further gains in the market or taking part in large losses? Investing all of your cash at once gives you a higher probability of taking part in larger gains but also taking part in larger losses. To decrease market risk and sleep better at night, dollar cost averaging in a higher valuation environment can lead to a smoother ride and give a lower probability of seeing large losses.”