Lump sum or cost averaging?
Having a big wad of cash to invest means not only deciding what to buy, but when.
If you’re hesitating between investing the money all at once or through regular deployments at set intervals (known as cost averaging in dollars), be aware that you’re more likely to end up with a higher balance down the road by doing a lump sum-sum of investment, a study by Northwestern Mutual Wealth Management shows.
This outperformance is true regardless of the combination of stocks and bonds you invest in.
“If you look at the likelihood of you ending up with a higher cumulative value, the study shows that this is mostly when you use a lump sum investment. [approach] relative to the average dollar cost, âsaid Matt Stucky, senior equity portfolio manager at Northwestern Mutual Wealth Management.
The study examined the 10-year rolling returns of a million dollars from 1950, comparing the results between an immediate lump sum investment and the average cost in dollars (which, in the study, assumes a million dollars is invested evenly over 12 months and then held for the remaining nine years).
Assuming a 100% equity portfolio, the lump sum return on investment exceeded the dollar cost on average 75% of the time, according to the study. For a portfolio made up of 60% equities and 40% bonds, the outperformance rate was 80%. And a 100% fixed income portfolio has outperformed the dollar cost on average 90% of the time.
The average outperformance of lump sum investments for the all-equity portfolio was 15.23%. For a 60-40 allocation it was 10.68%, and for 100% bond it was 4.3%.
Even when markets hit new highs – which is the current theme of major indices – the data suggests that a better outcome over time always means putting your money in at the same time, Stucky said. And, compared to lump sum investing, choosing an average dollar cost instead can feel like market timing, regardless of how the markets are performing.
âThere are a lot of other times in history where the market has felt high,â Stucky said. “But market-timing is a very difficult strategy to implement successfully, whether by private investors or professional investors.”
However, he said, averaging dollar costs isn’t a bad strategy – typically 401 (k) plan account holders do it through their employee contributions throughout the year. year.
Also, before you put all your money in stocks, for example, all at once, you might want to familiarize yourself with your tolerance for risk. It is basically a combination of how well you can sleep at night during times of market volatility and how long until you need the cash. The construction of your portfolio – that is, its combination of stocks and bonds – should reflect this tolerance for risk, regardless of when you invest your money.
âFrom our perspective, we’re looking at 10-year time horizons in the studyâ¦ and market volatility during that time will be a constant, especially with a 100% equity portfolio,â Stucky said. “It’s better if we have expectations in a strategy than to find out later that our tolerance for risk is very different.”