By Peter Mastrantuono
Many investors practice dollar cost averaging through regular, periodic investments in their 401(k) accounts. In situations where an investor has a lump sum of cash to invest from a sudden windfall or bonus payment, they are faced with a big question: “Should I invest the entire amount immediately or invest equal portions of it at regular intervals over a prescribed period of time?”
The hesitation most individuals have with investing the lump sum all at once is the concern that the market will drop subsequent to their investment. Dollar cost averaging mitigates this risk by investing equal amounts of the lump sum, for example, on a monthly basis for the next 12 months. In this way, the funds invested are buying more shares when the price is lower and fewer shares when the price is higher, thereby reducing the average price of entry into the market.
Dollar cost averaging does not guarantee an investor against a loss, but it can smooth out the volatility of the market.
What the Research Shows
History can be an excellent guide in answering the question of whether to invest immediately or dollar cost average. In a recently publish study, Northwestern Mutual examined all rolling 10-year returns since 1950 to determine which approach resulted in the higher cumulative gain. (The dollar cost averaging was over the first 12 months of the 10-year period.)
Their analysis was performed on three basic portfolios: 100% equities, 60% equities/40% bonds and 100% bonds.
In all portfolio scenarios, the lump sum approach outperformed the dollar cost averaging alternative quite handily. In the case of the 100% equity portfolio the lump sum performed better nearly 75% of the time, with wider margins for the 60/40 portfolio (80% of the time) and 100% bond portfolio (89% of the time).
The reason for why a lump sum investment approach is usually the sounder decision is that markets tend to go higher. Sure, there are bear markets and corrections, but generally stock prices trend higher. In the case of bonds, which have much less volatility, investment of the entire lump sum right away means that an investor is earning a higher yield immediately rather than temporarily keeping a portion of the lump sum in lower-yielding cash investments.
An earlier analysis by Vanguard came to a similar conclusion.
Beyond the Numbers
While history should inform an investor’s decisions, individuals, nevertheless, need to factor in their own risk tolerance and current market conditions.
If an investor will feel regret or lose sleep from a meaningful drop immediately following a lump sum investment, then there may be good reason to dollar cost average, regardless of what the numbers tell us.
If an investor believes that the market is about to correct from its current lofty levels, then dollar cost averaging may be the smarter approach, even if calling a market top is a hit-or-miss (mostly miss) proposition.
In the final analysis, investors ought to consider whether they will really care ten years later which method they used when, for example, the S&P 500 index was trading in a range of 1,200 to 1,300 in 2011 versus today’s roughly 4,500 level.
The more critical issue is whether investors are making that windfall investment within the context of an overall financial and investment plan, and if they are working with an experienced financial advisor to help identify suitable investments that will work hard for them.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.