Over our lifetimes, some of us will be fortunate enough to come into a substantial amount of cash in one lump sum. Supposing that the lucky one is not in the market for a new jet, the question is: What’s the best way to invest it?
The question really has two parts. Let’s deal with the easiest first. Such a windfall should be viewed as an integral part of an investor’s portfolio, not as a standalone entity. It should be invested in line with the investor’s existing asset allocation. The second part is the timing: Should it be invested all at once, or gradually?
The answer is both simple and complex at the same time because it involves a conflict between statistics and the psychology of human behavior. The statistics tell us that all at once will likely provide a better return than gradually. But human behavior studies show that a loss of a given dollar amount is about 1.5 times as painful as a gain of the same amount. This means that many of us may be willing to forgo some likely gain if it means that we will be less likely to suffer a significant loss.
Let’s look at what a variety of studies show about immediate investing versus dollar-cost averaging — dividing the lump-sum in a number of equal parts and investing each one periodically. For example, dividing by 12 and investing each part once a month for one year.
One study looked at every 12-month period from 1926 through mid-2014. A lump sum would have an average return of 9.57 percent (assuming a 60/40 stock/bond allocation). A three-, six- or 12-month DCA would have had average returns of 8.85, 7.61 and 5.17 percent, respectively. The difference between the 12-month DCA and the lump sum method is 4.58 percent, a significant difference.
The study makes other important points: The worst 12-month loss for the lump sum was 42 percent, versus 32 percent for the 12-month DCA. The best 12-month gain for the lump sum was 103 percent, versus 44 percent for 12-month DCA. The study also concluded, “. . . the percentage of times DCA provided meaningful protection for a portfolio was quite small compared with the number of times it provided a meaningful drag to portfolio performance.”
Another study used the period from 1926-2013 and showed similar results. It compared lump-sum investing to 12-month DCA. This study assumed no bond allocation; investments were in the S&P 500. The average 12-month lump-sum return was 12.2 percent, versus 8.1 percent for 12-month DCA.
Overall, the studies I have reviewed suggest that lump-sum investing will outperform 12-month DCA about 60 percent of the time.
These results should not be surprising. Simple statistics show that the stock market is upwardly biased. Historically, the stock market has tended to provide an annual compound inflation-adjusted return of almost 7 percent. Additionally, the stock market has been higher on Dec. 31 than it was on the previous Jan. 1, about two-thirds of the time.
No matter what the statistics show, however, the psychological study of human satisfaction and regret may legitimately take an individual investor in a different direction.
For highly risk-averse investors who react negatively to short-term losses, it might make sense to ignore the statistics and invest the lump sum gradually. This will eliminate the possibility of the investor feeling regret because he or she invested the lump sum and the market immediately has a large decline.
If at the end of, say, 12 months, the 12-month DCA return was less than the lump sum’s return, the investor can view the difference as simply an insurance premium akin to life or fire insurance. - heraldtribune
No comments:
Post a Comment