I have a substantial amount of cash on the sidelines I want to invest in a diversified portfolio of funds. But I believe we're in for a market correction sometime soon. I know you've said that dollar-cost averaging isn't a good strategy, but I was wondering whether in this scenario it makes sense as a way to overcome my paralysis about investing my money while also reducing my risk? --David
You're right. I have noted in the past that dollar-cost averaging isn't a particularly smart way to protect yourself against the possibility of market setbacks. Still, I can understand why you -- and many others -- might still be tempted to use this strategy.
After all, if your suspicions prove correct and you invest your dough after the market drops instead of before, you'll not only have sidestepped losses from the downturn, you'll also be in a position to invest your money at more favorable prices. That would be a nice win-win. Problem is, however much you may be convinced the market is headed for a correction (or even worse, a full-fledged bear market), you can't really know that.
I'll grant that there are valid reasons to be wary about the market's future prospects even though stock prices have been on a roll lately. For example, more than half of asset managers recently surveyed by Northern Trust Asset Management said they believe U.S. stocks are overvalued.
And the fact that this bull market has been underway more than eight years already and that stocks have surged some 250% since their post-financial crisis lows leads some investors worry that the market is bound to stumble at some point.
And no doubt it will. But being sure when that point has arrived is another thing. For example, many investors thought the bull market's days were numbered last summer in the wake of Brexit, or the UK's vote to pull out of the European Union. But although stock prices slid more than 5% in the days immediately after the vote, the market bounced back.
Similarly, some investors believed that a Trump victory in the presidential election would send stock prices reeling. Indeed, two economists published a paper before the election that estimated a Trump win could trigger stock losses of 10% to 15%. In fact, stocks rallied. Which shows that no matter how (pick one: sure, convinced, absolutely certain) we may be that stocks will plummet, or soar, it's really just a guess.
So, given that you can't know what the market is about to do, the question is whether dollar-cost averaging is an effective way to deal with this uncertainty.
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One way to answer that question is to see how investors would have done in the past by pursuing a dollar-cost averaging strategy vs. investing all at once. A recent Vanguard study explored that very issue, comparing how an investor with a large sum of cash would have done by investing that money immediately into a portfolio of stocks and bonds vs. moving the money gradually into the same stocks-bonds mix.
So, for example, when Vanguard researchers looked at how someone investing a lump sum of cash all at once into a portfolio of 60% stocks-40% bonds vs. moving the cash into that 60-40 blend over a period of 12 months, they found that investing the lump immediately beat dollar-cost averaging about two-thirds of the time in the 1,069 rolling 12-month periods from 1926 through 2015.
When the researchers repeated the analysis over both six-month and 36-month periods over the same 90 years, the result was the same: investing the cash all at once came out ahead about two-thirds of the time in the case of six-month periods and 92% of the time over 36-month spans. What's more, the outcome was pretty much the same whether one moved from cash into a more conservative 50-50 mix of stocks and bonds or, for that matter, a portfolio of 100% stocks or 100% bonds.
These results pretty clearly show that you're generally better off investing your money all at once rather than dollar-cost averaging. They shouldn't come as a shock, though. Both stocks and bonds generally outperform cash, so it makes sense that the longer you take to move cash into either of those assets or a combination of them, the lower your return is likely to be in most cases.
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The other way to look at this issue is by stepping back and really thinking about what you're doing when you dollar-cost average. You say that your goal is to invest the cash you have on the sidelines in a diversified portfolio of index funds. By "diversified portfolio," I assume you mean a mix of stock and bond funds that makes sense for you based on how long you plan to keep your money invested and how much risk you're willing to take. You can arrive at a mix that's appropriate for you by completing this risk tolerance-asset allocation questionnaire.
Just for the sake of this example, let's say that you decide an asset allocation of 70% stocks and 30% bonds is right for you. In other words, you realize that you can't call the ups and downs of the market. But you feel that the 70% stocks position gives you enough of an opportunity to reap stocks' gains when the market is doing well, and the 30% in bonds provides enough downside protection so you won't panic and sell when the stock market tanks. In other words, a 70-30 mix is one that you'll feel comfortable sticking with in good markets and bad.
So the issue then becomes how do you get your cash on the sidelines invested in that 70-30 mix? You could dollar-cost average your way into it. If you're sitting on, say, $120,000 in cash, you could move $10,000 a month into your portfolio ($7,000 a month into stocks and $3,000 into bonds), and by the end of the year you would be fully invested in stocks and bonds.
But look at what you've actually done by investing gradually instead of immediately putting 70%, or $84,000, of your $120,000 in stocks and 30%, or $36,000, in bonds. You started with an allocation of 100% cash. At the end of three months of transitioning out of cash and into stocks and bonds, your portfolio will have only 17.5% in stocks and 7.5% in bonds. (For simplicity's sake, I'm not including any returns these assets might have earned over that period.) After six months, you'll still have only 35% in stocks and 15% in bonds. And even after nine months, only a little more than half (52.5%) will be in stocks and 22.5% in bonds (with the remaining 25% still in cash). In short, you'll have spent an entire year investing more conservatively than the 70-30 mix you decided was right for you.
Or, to look at it another way, you'll have gone through a series of monthly asset allocation mixes that are more conservative than the one you've settled on as appropriate for you. In short, by dollar-cost averaging, you are contradicting yourself. On the one hand, you're saying that 70% stocks-30% bonds reflect the mix of risk and reward that's right for you. But you're then undermining your asset allocation strategy by investing much more conservatively for a year.
If you look at dollar-cost averaging from this point of view, I think it's pretty clear that the strategy is an imprecise and inefficient way to invest in the face of uncertainty. And that's true whether you're building a portfolio from scratch or adding a large sum -- an inheritance, a windfall, rollover funds from a retirement account, whatever -- to a portfolio you already have.
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As for your question of whether dollar-cost averaging makes sense as a way for you to overcome your paralysis about getting into the market, I'll admit that, yes, dollar-cost averaging could be considered a valid strategy if it gets you to do something you wouldn't otherwise do -- i.e., invest in those stock and bond funds. But I'd hope that after thinking it through, you'd decide not to dollar-cost average and instead focus on finding the appropriate asset mix for you and investing your money accordingly.
But if you really can't do without the psychological crutch of dollar-cost averaging, then I suggest at least minimize its shortcomings by reducing the amount of time it takes to get to your target asset allocation. Instead of dollar-cost averaging over a year or longer, do it over six months, or better yet three. That may not be as effective going to your target allocation immediately. But it's better than stringing it out even longer.
