Taking the Plunge (Into the Stock Market): To Jump or to Wade?
Summer left without so much as a goodbye... and now it's fall! Now that the thought of swimming is more chilly than refreshing, I think you can relate to this. I am convinced there are two types of people: Those that jump right into the cold water, enduring the shock of the cold but getting it over with, and those who gradually ease into it, hoping to minimize the impact of the cold as they wade in, little by little.
I'm sure you know exactly which kind of person you are in this context. But when it comes to investing, we get asked about this a lot. “I’ve got some cash to invest – do I put it all in the markets right away, or should I put it in over time?” In investing terms, we’re talking about “lump-sum investing”, in which the full amount of money is invested up front, and “dollar-cost averaging”, or diversifying the cost of buying into the market via investment contributions made in installments over time.
Let’s take the example of two investors who each have $12,000 cash to invest. One puts $12,000 into the market immediately (lump-sum) and the other invests $2,000 a month for six months (dollar-cost averaging). If the market increases in value over the first six months, the second investor will pay a higher average price than the lump-sum investor. If the market decreases over the same time period, the opposite would be true.
While investors may focus on the price(s) of the market when buying in, it’s important to remember that a meaningful portion of the second investor’s capital is in cash over the period of time they are easing into the market. Half of their investable assets, on average, are forfeiting the higher expected returns of the stock market. For investors with the goal of accumulating wealth, this could lead to a significant opportunity cost.
A great fear many investors face is: “What if I make an investment today and the market drops right after?” There will always be the chance that an investor chooses to invest a lump sum just prior to a significant market decline. That is part of the risk of investing. Alternatively, market declines are usually caused by some event or series of circumstances, and it can feel just as risky to put money in when things are bad and may get worse. We never know the “perfect timing” until we’re looking in the rearview mirror - and that’s part of the fear.
The chart below puts those fears in a broader context. It shows the average annualized compound returns of the S&P 500 from 1926–2019 after a) the index has hit all-time highs, and b) after the S&P 500 has fallen more than 10%. In both cases, subsequent 1, 3 and 5-year returns are positive.
Highs and Lows
Average annualized compound returns after market highs and declines, 1926–2019
Overall, this data demonstrates that recent market performance should not influence the timing of investing in stocks. And, in both cases, investing within one year resulted in higher returns.
So – back to the original question: What’s better for investors – jumping into the cold pool (lump-sum investing) or wading in (dollar-cost averaging)?
The data suggests that lump-sum investing is the more efficient approach to building wealth over time. The biggest challenge to face is fear, but the shock of jumping into the cold pool is generally rewarded with greater returns over the long-term, as all the cash is deployed, invested and earning interest over the entire time period.
That said, dollar-cost averaging is a reasonable strategy for investors for whom the fear of a large downturn after investing a lump sum might keep them out of the market altogether. If that’s the case, data shows that dollar-cost averaging over a period of time no longer than six months is recommended. (Any longer than six months, and the opportunity cost of dollar-cost averaging exceeds any potential benefits). Also important to consider: The stock market has a dividend yield of about 2%. Should an investor pursue a dollar-cost averaging approach, the lost dividends are yet another return hurdle that must be overcome.
All of this to say, there is no perfect approach. We each have our own objectives, risk tolerance, experiences, fears, and investment time horizons. Thoughtful consideration and intentional decision-making in choosing the approach that feels right to you is always the best choice, regardless of what decision was “right” at the end of the day.
As your advisors, we appreciate the opportunity to be your trusted resource and are happy to help you decide which approach — lump-sum investing or dollar-cost averaging — is better for you at a given time and circumstance. Markets have clearly rewarded investors over time, and so whichever method you may choose, the goal is the same: developing an intentional plan and having the discipline to stick with it.