So, you’ve just come into a lot of money; maybe it was from the sale of a business, inheritance, rolling over of an old 401(k), or settlement. However you came into it, the money needs to be invested…but how should you do it?
Before we dive in, it’s important to remember that human beings are emotional, irrational creatures and, unfortunately, the stock market could care less about your feelings. Recognizing this will help as we analyze the different options available to us in deploying your capital.
As financial advisors, it’s our job to stand at the cross-roads between what the rational, robotic approach should be and what will make you sleep well at night and feel confident going forward. Rational, robotic approaches make sense in theory but human advice you can trust helps you navigate your feelings and handle your finances in a more pragmatic manner. It’s our job to help you consider your options when investing a lump sum of cash: Should you invest the whole sum immediately or use the dollar cost averaging approach?
Let’s look at the pros & cons of both approaches.
Dollar Cost Averaging:
Let’s say you have $750,000 you are looking to invest. Imagine if you invest your cold-hard cash just to find out you got into the stock market at the top. In the Great Financial Crisis, the S&P 500 lost 56.8% from its top on October 9th, 2007 to its bottom on March 9th, 2009. Suddenly, your hard-earned $750,000 of cash is worth $426,000 and you have no idea when the market will bounce back. With something that emotionally scarring to your finances, do you really think you remained a rational, sound investor and kept your money in the market to ride the rebound back up? We can easily see this happening with some of the volatile swings we have already seen in 2020.
Dollar cost averaging (DCA) can be a fantastic way to manage the risk associated with buying at the top of the market. With this approach we split $750,000 into several smaller stages of investment spread over time. You do this all the time with your 401(k) without even knowing it: By consistently contributing every two weeks out of your paycheck, you’re spreading out the risks associated with buying in at the top of the market. As the market fluctuates, each contribution buys in at a different share price, some higher and some lower. Over time, you’ve mitigated the risk of only purchasing at the top, making you feel more confident about investing your hard-earned money!
Here’s an example
Imagine investing $250,000 of the $750,000 each month for three months until the full account is implemented. The current price per share of what you’re purchasing is $150/ share in month one, $125/ share in month 2, and $175/ share in month 3. If you’d put all $750,000 to work right away, you’d have 5,000 shares. However even with buying $25/ share above and $25/ shares below in a DCA strategy you end up 95 with more shares!
In this situation, dollar cost averaging helped you avoid purchasing at the peak and over a period of time gave you the opportunity to purchase more shares than a lump sum would have. However, that’s not quite the full story because while the variation of $25 above and below the original $150 share price may be proportional in terms of dollar amount, they aren’t proportional in terms of return. Take a look at the far-right column of the chart when we analyze the percentage swing around the initial $150 share price.
As you can see, while it may be proportional in terms of dollar amount, the mathematics of the returns show you aren’t receiving proportional returns because the smaller share price is working off a smaller denominator! While the Dollar Cost Averaging method is effective from a behavioral side and can help with mitigate the risk of investing at the peak, you’ll lose vs. lump sum investing if markets stay flat or rise.
The Case for Lump-Sum Investing:
The stock market historically goes up more than it goes down, so lump-sum investing from a rational, mathematic standpoint make a lot of sense. An analysis of the Wilshire 5000, which represents the 5000 largest US companies, shows that since 1971 there is a 64% probability of the stock market being positive month over month to only a 36% probability of the market being negative.
A rational, unemotional argument would say that if you believe markets have a higher probability of going up than down, it shouldn’t matter when you put money into the stock market if you’re a long-term investor. Frankly, the numbers would support this argument. There’s a 28% higher probability of the stock market being positive than being negative!
But here’s the problem: Human beings aren’t rational, unemotional creatures. The news has a way of spooking us and it’s the rare investor who can watch the market tank and sit calmly without fear. And that, again, is why working with a financial advisor is so important. We can help you navigate the difficult choices that come with investing in uncertain times.
To Sum it Up
Dollar cost averaging makes investors feel more comfortable about investing in the stock market and provides risk management along the way from large, volatile downswings. Getting our clients to understand and feel comfortable with the risks they’re taking with their money helps them deal better with the volatility in the stock market and stick to the plan. Yes, month over month the stock market goes up 28% more often than it goes down, but if you keep your cash on the sidelines because you don’t know when the right time to invest is you’ll lose much more than you will with the dollar cost averaging method.
Denver Private Wealth Management is an independent fee-based financial planning practice with 50+ years of experience in the financial industry. DWPM customizes portfolios based on your financial goals and works closely with you, your tax advisors and estate attorneys to form a comprehensive view of your financial situation. For more information or to set up a free consultation, contact us at email@example.com.
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