The best way to invest a windfall
Many people who are saving for retirement or college invest a fixed amount of money on a regular basis, such as every time they’re paid. This approach, often referred to as dollar-cost averaging, reflects the fact that few investors have vast sums of money sitting around, waiting to be invested.
The question arises, however: If you do have a lump sum to invest — perhaps you received an inheritance or have pocketed the proceeds from a home sale — should you put your money into the market all at once? Or, are you better off investing as you normally would, and putting portions of your money into the market over time?
Reducing the chance of regret
At first glance, it may appear that a gradual schedule is safer, as you won’t have to worry that stock prices will plummet the day after you plunk down a large sum. This thinking is called “loss minimization,” says George Constantinides, professor of finance at the University of Chicago. You want to reduce the chance that you’ll regret your actions. Because no one knows what the market will do, it might seem like you can hedge your bet by getting into it over time.
However, “this decision is not supported by any rational decision making (model),” Constantinides says. In fact, the research shows that most of the time you’ll end up with more money if you invest a lump sum all at once.
Consider the work done by Gregory Singer, director of research, and Ted Mann, analyst, both with Bernstein Global Wealth Management. They calculated the results of investing in the Standard & Poor’s 500 using both lump sum investing, as well as dollar-cost averaging, for all the rolling 12-month periods between 1926 and November 2008.
The average yearly return for the “lump sum” approach, or investing everything at the beginning of the year, was 12 percent. That compares with 8 percent under dollar-cost averaging. Their research appeared in the April 2009 issue of Trusts & Estates. (For periods prior to 1974, Singer and Mann used the overall return on the stock market.)
Why doesn’t dollar-cost averaging come out ahead? Singer and Mann point out that the stock market has tended to rise in value over time. That means that while some of your money is sitting out for even part of a year, you’re probably losing potential gains.
An even bigger risk to dollar-cost averaging is that you’ll delay, second-guess yourself and not get into the market for several years, says Charles Bennett Sachs, CFA, CFP and vice president and wealth manager with Evensky & Katz Wealth Management in Coral Gables, Fla. While you would avoid the market declines, you also would miss the upside.
Some protection in bad markets
To be sure, Singer and Mann found that dollar-cost averaging provided some protection in poor markets. When they focused on the 12-month periods between 1926 and 2008 that fell into the bottom 20 percent of performance, they found that dollar-cost averaging provided an average of 11.6 percent more wealth than investing all at once.
However, in typical and strong markets, dollar-cost averaging left investors with 2.9 percent and 13.4 percent, respectively, less wealth than investing using a lump sum approach. That means the protection dollar-cost averaging offers in poor markets comes at a price.
Instead of trying to time the market, it makes more sense to focus on asset allocation, says Robert Dubil, associate professor and lecturer in finance at the University of Utah in Salt Lake City. “Diversifying your assets is more important than diversifying over time.” So, when investing a lump sum, you first would decide the allocations between different investment types. Then, you would get into the market at one time, and maintain your allocation parameters by rebalancing on a regular basis.
If, despite the research, you’re still nervous about diving into the market in one swoop, you’re best off scheduling your investments over a period no longer than about six months, Singer and Mann found. You’ll gain about 7 percent in protection against market drops, while giving up just 1 percent in return. Drag out the process to more than about 18 months, and you’ll gain little additional benefit, but will see your return drop by about 6 percent in typical markets.
This isn’t to say that dollar-cost averaging has no role in saving and investing plans. It does. However, for most people it is more of a budgeting tool than an investment strategy, says Robert Atra, CFA and chair of the finance department at Lewis University, Romeoville, Ill. Most investors squirrel away smaller sums on a regular basis rather than a large sum all at once, because that’s how their money comes in.
If you’re fortunate enough to have a lump sum to invest but jumping into the market all at once will keep you up at night, dollar-cost averaging over a short period of time can offer some protection at a relatively modest cost. What is less effective is to “become a market timer and have cash pile up because you think some times are better than others,” Sachs says.