A reader writes in, asking:
“I have about $200,000 of cash that I’m looking to deploy. I have settled on the “coffeehouse” allocation a la Bill Schultheis. [Mike's note: See here.] But I am weighing the pros and cons of getting in at once or in increments over time.”
This is one of those classic investing questions that get asked over and over. Fortunately, there’s no shortage of research addressing the topic.
For example, a Vanguard study from 2012 used historical returns in the U.S., the U.K., and Australia to compare the results of dollar-cost averaging (that is, spreading out the investment over time) as opposed to lump-sum investing. The conclusion: Relative to investing the money all at once, dollar-cost averaging typically results in lower returns and lower risk.
And that outcome is precisely what we would expect, given that (relative to investing the money all at once) dollar-cost averaging results in a higher average allocation to cash and a lower average allocation to stocks over the period. In other words, dollar-cost averaging (as an alternative to lump-sum investing) doesn’t achieve anything magical. It just slows down the rate at which you move from cash into your targeted asset allocation.
And therein lies the problem with spreading out the investment over time. If you really do think your targeted asset allocation will be a good fit for you several months from now, why wouldn’t it be a good fit right now as well?
Is Your Target Allocation a Good Fit?
Before making big changes to your asset allocation (i.e., by moving out of cash and into stocks and bonds) it’s important to do some thinking about your risk tolerance.
For example, if the lump sum of cash is the result of an inheritance that dramatically increased the size of your overall portfolio, there’s a good chance that your risk tolerance is different from what it was prior to receiving the inheritance.
Or, if the reason you have a pile of cash sitting around is that you sold all your stock holdings at the beginning of 2009 and it’s taken four calendar years of positive returns for you to start thinking about getting back into the market, then you probably have a fairly low risk tolerance — much too low for the allocation that you held prior to getting out of the market.
In other words, if you’re experiencing significant hesitation about moving into your desired asset allocation, you should consider the possibility that that’s a sign that the allocation you have planned to use is not actually a good fit for you.
In that way, dollar-cost averaging actually can be useful for testing out your target asset allocation. Implement it with a piece of your portfolio and see how it feels. Of course, ideally, the test should encompass both a bull market and a bear market — and that would likely take several years. Still, if you’re experiencing anxiety about making the change, even a brief test may be preferable to no test.