If you’ve pulled money out of the markets or you’ve received a large chunk of money, here’s how you can put it back to work.
- Dollar Cost Average
- Lump Sum Investment
Dollar cost averaging (DCA) is where you invest in pieces over time – the same dollar amount over a specified time period. For example, if you had $100,000 to invest. A DCA strategy could be to invest $16,667 each month over the next 6 months.
A lump sum investment strategy is plunking all the money at once back into the markets and your target allocation. For example, you invest $100,000 on day 1.
Which is better?
Technically speaking, the lump sum investment strategy will result in more money. This is because the sooner you are settled in a long-term allocation, then the sooner compound interest can start working for you since markets (historically) have moved up over time. By starting immediately, compound interest has the maximum amount of time to grow.
But I know that markets will fall once I put all that money in! The markets are out to get me!
Hey, I’m just telling you what the math says. And I completely understand this sentiment because I hear it all the time.
Truth be told, for my clients I utilize the dollar cost averaging strategy most of the time. It is a miserable experience to watch your money go down in value. It is even more painful when you just put everything in. Don’t try to math your way out of that one – it’s gut wrenching.
As such, here’s what I do for clients:
I select a time frame from 3-12 months to implement the DCA strategy. This time frame is completely dependent on my personal conversations with the clients and their feelings (I don’t go longer than a year because research shows that even if the market takes an immediate dive – which then would be a positive for a DCA strategy relative to lump sum – your equity purchases that are spread over multiple years are too far out and you’ll do worse off than if you had done a lump sum. It totally defeats the benefit of getting lucky that the markets took a dive but you didn’t go all in.
Day 1: I purchase all the bonds in their long-term allocation.
Then on the 1st of every month I’m purchasing global equities until the client’s overall allocation matches the long-term allocation we’ve agreed upon.
It’s not about the timing or a specific day, it’s about being consistent and completely ignoring what’s going on everywhere else.
Let’s say we have a $1mm portfolio that’s long-term allocation is 50% equities and 50% bonds, and we’re going to DCA over 6 months. Here’s every step of the strategy:
Is it perfect? Absolutely not. But what’s the goal here? We’re trying to build a long-term allocation so that their money lasts for their entire retirement. As such they need to hold an allocation of equities and bonds. This is our way of getting them there.
Why don’t we just buy when the market is down?
If we’re being honest even after all the math and research into investment strategies, they still don’t seem to do the thing we desire: Avoid the risk of loss.
Why not just buy when the market is down and avoid losing money? This seems to be the most sensible thing to do.
Research done by Nick Maggiulli proves otherwise. Here are links to two articles: Even God Couldn’t Beat Dollar-Cost Averaging & Why Buying the Dip is a Terrible Investment Strategy. I’ll do my best to summarize my favorite points below:
Historically, markets have gone up over time. If you had decided to wait until there was a 20% dip, then you might be waiting a long time until that happens. If the market doubles from now until then, prices would still be 60% above from where they started. You get the joy of buying in at the right time only to have it erased by the fact that you paid a 60% premium.
“Buying the dip” does in fact work IF you get it exactly right. Going back to the 1920’s, buying dips only outperforms a DCA strategy 30% of the time (So you’re saying there’s a chance!)
But if you don’t get it right, then your underperformance is even worse! It’s an asymmetric payoff. If you’re right, you win by a little, but if you’re wrong then you lose by way, way more. (This is sounding less prudent by the minute).
In fact, if you miss timing the bottom by 2 months, then your chances of outperforming DCA drops from 30% (which was bad from the start) to 3%!
Buying when the market is down is more of being lucky than an actual investment strategy.
Now you know the facts. What will you make of it?