Mar 16, 2021 Investment Question of the Month: Should I invest my cash now or over time?
If you have cash sitting on the sidelines, you have options to get it invested. Here are three of the most common options to get it invested:
- Invest it right away (lump sum)
- Invest it over time (dollar-cost average)
- Invest when the market pulls back (time the market)
Each option has pros and cons, but research suggests investing it right away has been a prudent strategy. Investing it over time is also a sensible strategy and can help reduce the impact of the market dropping just after you invest. Investing when the market pulls back sounds nice but is very hard to do.
Timing the market is challenging. You may be waiting a long time for the market to pull back. You also run the risk that the market may never pull back to the level you could have initially invested. Further, if markets do pullback to that initial level, many investors find it difficult to buy due to the fear of further losses. What often ends up happening is that the cash stays uninvested for longer than intended, and you may end up with lower returns.
Investing right away has been the most profitable strategy in the past. Generally, the longer you wait to invest, the lower your returns will be. This makes sense because historical market returns of stocks and bonds are greater than returns on cash. By investing right away, you would have gained exposure to higher returning assets as soon as possible, resulting in higher returns on average. However, there were several periods right before a significant decline that this would not be the case.
Research from Vanguard looked at different portfolios in the US, UK and Australia. Vanguard compared the one-year historical performances of an immediate lump sum investment against 12 equal monthly purchases. The lump-sum beat the dollar-cost averaging about two-thirds of the time. The average outperformance ranged from 1.45% in Australia to 2.39% in the US. This chart sums it up nicely. 1
While the data suggest investing your excess cash right away is the superior strategy on average, a dollar-cost averaging strategy may be best to combat the risk of an impending decline. Markets are volatile and large declines do occur. These declines can be psychologically challenging, particularly if the decline happens just after you invested a large amount of cash. An extreme decline can also permanently impair your financial plan.
Dollar-cost averaging can be appealing because it limits the loss in a worst-case scenario. If the market were to decline, not only do you lose less because you have cash waiting to be invested, but you are also able take advantage of the decline and buy at lower prices. The downside of this strategy, is that if markets go up while you are dollar cost averaging, you will be buying at higher prices compared to the lump sum strategy.
Overall, dollar-cost averaging can help you overcome the hurdle of mistiming your initial investment by stretching your buys out over multiple price points. It can give you peace of mind that you will not wholly mistime the market. And it gets your cash working in investments that have a higher expected return than cash. It is better to dollar-cost average than not start at all.
*Important Note: Dollar cost averaging does not increase your portfolio return. There can still be a risk of loss.
Disclosures: Vanguard methodology:
Our analysis uses monthly stock, bond, and cash returns in the United States, United Kingdom, and Australia to evaluate the historical performance of immediate and systematic implementation plans. For immediate implementation, we assume that local currency (USD, GBP, or AUD) is immediately invested into a stock/bond portfolio. For systematic implementation, we assume that the same sum starts in a portfolio of cash investments and is transferred in equal monthly increments into a portfolio over 12 months. Each portfolio consists of a 60% allocation to the local equity market and a 40% allocation to the local bond market using the indexes outlined below. We used total return for our calculations. Both portfolios are rebalanced monthly to the target allocation, and transaction costs are not factored into the analysis.
Once the systematic implementation period is complete, both portfolios have identical asset allocations. We then compare the ending portfolio values from each strategy to determine the relative percentage of outperformance and average magnitude of outperformance during rolling 12-month periods from 1926 to 2015 in the United States, 1976 to 2015 in the United Kingdom, and 1984 to 2015 in Australia.
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