There’s only one downside to getting a large cash windfall: deciding how to invest it. Do you put the lump sum to work right away, or do you invest in smaller increments over a longer period of time? While there are pros and cons to each approach, if you’re in a hurry, here’s the bottom line: invest the lump sum. Here’s why this strategy frequently outperforms the more popular technique called “dollar-cost-averaging”:
Dollar-Cost-Averaging is the process of investing an equal amount of money over a period of time, which could be 12 months, 12 years, or any other time period. The rationale behind this technique is to take advantage of something called “reversion to the mean.” This theory states that asset prices eventually revert to their long-term average. By investing gradually, you’re less likely to buy at a market peak or at a market bottom. On average, you’ll have paid an average price. (After all, no one likes to overpay.)
Lump Sum Investing is simply taking your money and investing it all at once based on your preferred asset allocation, for example stocks, bonds, money market, etc.
Buying the Dip is a technique that tries to time the market, aiming to buy on market dips thereby lowering average costs. While this sounds great in theory, it is unreliable in real life because no one, novice or expert, is able to time the markets consistently and reliably. A case study that looked at economic predictions by International Monetary Fund (IMF) economists found that their track record was abysmal. Out of 469 economic downturns since 1988, the IMF predicted a paltry four by the preceding year. (Note to self: Do not consult the IMF before making an investment.)
Based on studies in Canada and U.S., here’s why lump sum investing is the way to go if you receive a windfall:
Markets incline over the long term
Stock markets always trend upwards over longer time horizons. Yes, there are slips and even crashes along the way, but historically, as businesses and economies expand, stock markets rise. The longer our investments are out of the markets, the less time our assets have to grow. That’s why sitting on the sidelines while waiting to buy on a dip decelerates the wealth compounding effect.
Cash can be a drag
While it’s always important to keep an emergency fund of readily available cash, holding on to too much cash is a different kind of risk. Cash-based assets, such as GICs or money market funds, have lower historical returns compared to stocks. Over time, this lowers your total return, and it may not be sufficient enough to keep up with inflation and maintain your living standards.
One of the problems with “buying the dip” or dollar-cost-averaging, is, unless the process is automated, during severe market downturns very few investors will have the stomach to buy. No one can call when the market bottom has arrived; most of us are afraid to invest in case prices continue their freefall. And, once prices start to rise again, which they invariably do, we may be nervous about over-paying. Meanwhile, time passes and sitting on the sidelines becomes very costly in terms of missed gains.
And the winner is…
In a Canadian study that compared dollar-cost-averaging (DCA) to lump-sum investing in a balanced ETF portfolio (40 per cent bond; 20 per cent S&P/TSX Composite; 20 per cent S&P 500; 20 per cent MSCI EAFE), during the period of 1980 to 2017, the lump-sum strategy outperformed DCA 69 per cent of the time and by an average of 2.2 percentage points annually. In the investing world, this is a significant outperformance over a 37-year period.
No one frets about winning but we do worry about investing a lump-sum just before a big market crash. Imagine that you invested $100,000 and the next day the market dropped 30 per cent as it did in 2008. That wouldn’t feel so great. So, even though studies show that lump-sum investing provides superior returns, we’re still human. Here are some ways to address the emotional hurdles:
· How big is the lump-sum relative to your current savings? If the amount is small (20 per cent or less), experts recommend investing the lump-sum. However, larger amounts can be divided into segments, for example, half immediately and the remainder over a year or two.
· If the money came from an employee pension plan, invest the funds immediately in a similar way to keep them growing over the long-term.
Rita Silvan, CIM™️, is personal finance and investment writer and editor. She is the former editor-in-chief of ELLE Canada magazine and is an award-winning journalist and tv media personality. Rita is the editor-in-chief of Golden Girl Finance, an online magazine focusing on women’s financial success. When not writing about all things financial, Rita explores Toronto’s parks with her standard poodle.
Rita Silvan is a paid spokesperson of Sonnet Insurance.