19 Aug Pile Right In, Or Little By Little?
If you’re in the fortunate position of having a significant cash sum available for long term investment in the stock market, it can be hard to decide on the best approach for moving your money from cash to an investment portfolio.
Maybe you have this cash as a result of having sold a business, or it’s a lump sum you’ve taken from a pension plan. If so, the chances are this is a one-off situation, and you know that if you invest the cash and markets then plummet it would be almost impossible for you to make that money again.
Or maybe it is cash accumulated from saving as much of your income as possible for several years, and you’ve missed out on a lot of ‘fun’ spending. Yes, you could save the money again, but it would still be a massive kick in the teeth.
It’s often thought that making the decision when to invest is easier when markets are falling because what fool would buy stocks when markets are crashing?
But most people find it too challenging to go against what the herd is doing, so they sit on the side-lines with their cash, waiting for things to calm down. The problem then becomes, when is the right time to invest? In the majority of market crashes, stock prices tend to recover relatively quickly. So, while you’re trying to decide when might be the right time, markets suddenly turn, and before you know it, they’re up 10%, 15%. What then? Your problem now is knowing whether this is a genuine turnaround or just a dead cat bounce. So, you sit on the side-lines with your cash, waiting for things to calm down…
The reality is, investing is – as Warren Buffett said – simple, but it’s not easy.
One solution is to invest the cash gradually, over a number of months. Each month you will buy shares at a different price, enabling you to vary the cost over the period it takes you to be fully invested. This is known as ‘pound (or dollar) cost averaging’.
If prices go up each month, your overall cost will be higher than if you had invested the lump sum (especially if the uninvested cash is in a savings account paying you virtually no interest). The reverse is also true.
So which route is the best?
How has the stock market performed in the years following either a significant fall (more than 10%, the definition of a bear market) or after the market has reached a new all-time high?
Dimensional Fund Advisors (DFA) has crunched the numbers and analysed the results (applicable to the S&P 500) for the period 1926-2019:
Source DFA
Past performance is not a guarantee of future results.
In US dollars. New market highs are defined as months ending with the market above all previous levels for the sample
period. Annualised compound returns are computed for the relevant time periods subsequent to new market highs and
averaged across all new market high observations. Declines are defined as months ending with the market below the
previous market high by at least 10%. Annualised compound returns are computed for the relevant time periods after each
decline observed and averaged across all declines for the cut-off. There were 1,127 observation months in the sample.
January 1990–present: S&P 500 Total Returns Index. S&P data © 2020 S&P Dow Jones Indices LLC, a division of S&P
Global. All rights reserved. January 1926–December 1989; S&P 500 Total Return Index, Stocks, Bonds, Bills, and Inflation
Yearbook™, Ibbotson Associates, Chicago. For illustrative purposes only. Index is not available for direct investment;
therefore, its performance does not reflect the expenses associated with the management of an actual portfolio. “One-
Month US Treasury Bills” is the IA SBBI US 30 Day TBill TR USD, provided by Morningstar. There is always a risk that
an investor may lose money
Based purely on investment returns, the answer is that you should always invest the lump sum because market returns have significantly beaten the return from cash equivalents. So that’s the right answer, right?
Well, not necessarily. While investing a lump sum after either a considerable fall or a new market high would historically have given you sizeable returns in the following years, that’s just data. And data that doesn’t take into account the person behind the money.
Pound cost averaging might not be the most efficient approach, but it might be the one thing that gets you invested, rather than continuing to sit on the side-lines.
Giving up a little bit of investment return might very well be the price you are happy to pay for being able to sleep at night. Having a plan that you feel confident implementing and, most importantly, sticking with is going to be worth an awful lot more to you over the years ahead.
As is so often the case, the right answer can’t always be found in a fancy spreadsheet.
Carolyn