As I write this post the S&P 500 is about 100 points off it’s all time high of 2922, and climbing fast. We’ve seen an incredible bull market over the last ten years since the last financial crisis, and many people are wondering whether the next crash is around the corner.
So if you’ve just come into some money that you’d like to invest, is now a good time? What if you invest everything right before the market crashes again? Should you wait?
One popular strategy used in this situation is dollar cost averaging. Rather than invest everything at once or keeping your cash on the sidelines, dollar cost averaging parses out what you’d like to invest over time. The idea is that stretching out your investing over a longer period protects your savings against crashes. Basically, if the market does crash tomorrow you have less at risk.
For example, I have a client who just sold her business last year. She’s expecting to live off the proceeds raised from the sale for the rest of her life. We have a plan in place to help her accomplish this.
One of the big psychological hurdles we had to work through was how to go about investing this cash. While my client needs portfolio growth to ensure she doesn’t run out of money, the proceeds from her business sale account for over 70% of her net worth. Investing all of it at once was a nerve wracking idea! So we decided to dollar cost average the funds over the subsequent 12 months instead.
Dollar Cost Averaging vs Lump Sum
After studying this stuff for a while, I know that my client is likely to have a better outcome by investing everything at once. But that doesn’t help her sleep at night. The idea that the years of toil in her business could be washed away in an instant by neurotic Mr. Market was unacceptable. And even though she’s more likely to leave money on the table by holding back the cash during a growth period, this route made more sense for her.
Since then I’ve had probably half a dozen clients in similar situations. They have cash, but are reluctant to put it all at risk at once. While dollar cost averaging helps, I know intuitively that we’re more likely to miss out on potential returns than successfully avoid a crash.
But how much more likely?
There have been a few studies on this subject over the years (like Vanguard’s in 2012). But with the research tools I use in my practice, I figured I’d run the analysis myself out of curiosity. Especially since market returns since 2012 have been so strong.
I should also note that I grabbed the data for this post (and began writing it) back in December. Business got in the way, and it’s taken me a couple months to finish it up. Last month Nick Maggiulli of Ritholtz Wealth wrote a great post on the same topic. Ordinarily I don’t like to write posts that are similar to others I’ve recently read, but here we are. If you’re interested in the topic you should definitely read Nick’s post.
To start, I used the Morningstar US Market Index as a proxy for stocks and the Barclays U.S. Aggregate bond index for bonds. I chose the Morningstar index because didn’t want to omit small & mid cap stocks by using the S&P 500. I pulled monthly returns going back 20 years for both indices, including dividends & distributions. 20 years isn’t a tremendously long time, but it does capture the dot com bubble & bust, the mortgage crisis, and the last 10 years of market strength we’ve enjoyed.
Then I went to work calculating the returns of a 60/40 portfolio invested all at once, versus the same portfolio invested over a 12 month period using dollar cost averaging. I ran the exercise using rolling 3 year, 5 year, and 10 year periods.