A regular point of discussion with clients and prospective clients in investment planning is that, when they have a large sum of money to invest, it is not just about deciding what to invest in but when. Of course, each individual has his own set of unique circumstances and making these decisions comes down to what is laid out in their own financial life plan. Yet, this is always a common question for people.
If you’re debating between investing the money all at once or through regular deployments at set intervals known as dollar-cost averaging, be aware that you’re more likely to end up with a higher balance down the road by making a lump-sum investment. That outperformance holds true regardless of the mix of investment products you invest in.
If you look at the probability that you’ll end up with a higher cumulative value, a recent study shows it’s overwhelmingly when you use a lump-sum investment approach versus dollar-cost averaging. The study looked at rolling 10-year returns on $1 million starting in 1950, comparing results between an immediate lump sum investment and dollar-cost averaging which, in the study, assumes that $1 million is invested evenly over 12 months and then held for the remaining nine years.
Assuming a 100% equity portfolio, the return on lump-sum investing outperformed dollar-cost averaging 75% of the time, the study shows. For a portfolio composed of 60% equity and 40% fixed income, the outperformance rate was 80%. And a 100% fixed income portfolio outperformed dollar-cost averaging 90% of the time. The average outperformance of lump-sum investing for the all equity portfolio was 15. For a 60-40 allocation, it was 11%, and for 100% fixed income, 4%.
Even when markets are hitting new highs, which is the current theme with the major indexes, the data suggests that a better outcome down the road still means putting your money to work all at once. And, compared with investing the lump sum, choosing dollar-cost averaging instead can resemble market timing no matter how the markets are performing.
There are a lot of other periods in history when the market has felt high. But market-timing is a very challenging strategy to implement successfully, whether by retail investors or professional investors.
However, dollar-cost averaging is not a bad strategy. Generally speaking, RRSP or TFSA plan account holders are doing just that through their regularly timed contributions throughout the year.
Additionally, before putting all your money in, say, equity, all at once, you may want to be familiar with your risk tolerance. That’s basically a combination of how well you can sleep at night during periods of market volatility and how long until you need the money. Your portfolio construction, its mix of equity and fixed income, should reflect that risk tolerance, regardless of when you put your money to work.
The bottomline
From our perspective, they were looking at 10-year time horizons in the study and market volatility during that time was a constant, especially with a 100% equity portfolio. It’s better if we have expectations going into a strategy than afterwards discover our risk tolerance is very different.
The concept of investment timing and risk tolerance is the take away here. Investing in lump sums makes sense when it is available as opposed to dollar-cost averaging. In truth, both investment timelines are involved in most people’s portfolios. Ad hoc investing, as opposed to utilizing a proper strategy, will almost always diminish your portfolio potential. Discussing this with a financial advisor, and doing the appropriate planning, is pertinent to your investment success Keeping Life Current.
