Investing $600K: Lump sum vs. little by little
Dollar cost averaging may not guarantee you better returns than lump-sum investing, but it has other advantages that might bring a better yield over the long run.
(Money Magazine) -- Question: I have $600K in a money market that I plan to invest in Vanguard index funds. Should I put it in at once or dollar cost average in increments over a certain period of time?
The Mole's answer: The theoretical answer to this question is "invest it all now," but the practical answer is to "dollar cost average," if you can actually do it without second guessing yourself. Let me explain:
The first step in developing a portfolio is to select an asset allocation that meets your willingness and need to take risk. That includes deciding what portion of your portfolio you want in the stock market. If you've decided that $600,000 is the amount you want in the market, then doing it all at once will give you the highest probability of the best return for the risk level you selected. It's actually pretty clear cut from a mathematical viewpoint.
Most of us, however, don't view our lives mathematically. For example, if you had put this $600,000 in the market in March of 2000, it would have taken nearly a 50 percent hit two and a half years later. And if you were like most investors, the pain of this loss would have compelled you to sell long before the recovery began. Had you not sold, you would likely have seen your global set of index funds delivering some pretty decent returns over the total period.
Dollar cost averaging is investing small fixed amounts over regular intervals of time. While I disagree with those that use math to show that dollar cost averaging delivers superior returns to investing all at once, I am a strong believer that dollar cost averaging has significant psychological advantages. You don't have to worry about any worst-case-scenario market timing like the one described above.
If you dollar cost average in over a long period of time, say two or three years, you are actually more likely to stay in the market. If the market goes down, you'll feel better you didn't sink it all in at once, and because you're buying more shares at a lower price. So that's why I generally advise clients that come into a large sum of money to dollar cost average into the market.
But it's not quite that simple. It seems like it would be pretty easy, for example, to buy over the next two and a half years. All we need to do is divide the $600,000 by thirty months and then go out and buy $20,000 worth of shares each month. I've told my clients it doesn't matter when they buy, but it needs to be consistent. For example, on the third Thursday in every month just go out and buy it.
Unfortunately, just telling the client to dollar cost average turned out to be some of the worst advice I ever gave. I grossly underestimated our tendency to over think what should be simple. In many cases, clients went out and bought the first month and then slowed down or stopped. When they hesitated, they got scared. Their reasoning ranged from not wanting to buy because times were too uncertain, to believing a market drop was just around the corner. But they all resulted in missing out on market gains.
So now, when I give advice to dollar cost average, I make sure they set it on autopilot. Vanguard and most custodians allow you to set up an automatic investment plan that could withdraw a designated amount from your money market, checking or other account each month, and invest in the funds you choose. I'd strongly recommend doing it that way.
Be aware that this auto pilot plan isn't fool proof, as you will still have the ability to speed up, slow down or stop the purchases. But at least you'll have to take some action to change it, which might make you think twice before making a rash decision. So my advice is whether you invest the money over a one year period or a five year period, stick to the plan.
It's important to get things right when it comes to investing. I can't stress enough the importance of consistency, because the more inconsistent we are, the more we tend to time the market wrong. So if you can't be right, at least be consistent.
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More from the Mole in Money Magazine:
When to tell your planner you'll sleep on it: Why you shouldn't rush to act on advice, no matter how good it sounds.
Retirement: How much you'll really need: Sure you could live more cheaply in retirement. But some costs will go way up.
Payday for financial planners: Plenty of clients with plenty of cash and a shortage of advisors. That means clients will have to be even more watchful.