If you got a lump sum of money all at once, what would you do? Would you invest the money immediately, or invest it slowly over time? This decision point comes up all the time, especially in the case of large employment bonuses, cash inheritances, or any other “liquidity event”.
A common rule of thumb encourages a methodical “dollar-cost averaging” approach over some time horizon, like 3 or 6 months, where parts of the cash is invested to a target strategy. The idea, of course, is to avoid “market timing” and investing the entire balance at an inopportune time; for example, at a market top before a selloff. Dollar-cost averaging keeps the uninvested balance in cash, so the net result is an overall “less risky” profile compared to being fully invested.
There are some exceptions to this rule of thumb. For example, if the investor has a long time horizon and has a high risk tolerance there is no reason to be overly cautious getting invested to a target investment strategy. Also, if the new cash is a relatively small component of the investor’s total portfolio and not expected to impact the risk prolife, there is no reason to move slowly.
For every rule of thumb, however, there is a contrary view. Morningstar recently published an article titled, “The Dollar-Cost Averaging Myth” (Morningstar Magazine, 2020 Q1), where they attempt to debunk this approach. Through statistical simulations, they showed that dollar-cost averaging actually was a form of market-timing and, depending upon the scenario path, would produce less return and be more risky compared to a lump sum approach. Over a series of 10-month investment scenarios, the authors showed that dollar-cost averaging outperformed lump-sum investing only 27.8% of the time.
This is a logical conclusion since the market usually goes up and we would expect the “less risky” dollar-cost averaging approach to underperform “on average.” Importantly, however, the authors did not address a drawdown event that could wipe out 10%, 20% or 50% of a portfolio if the lump sum is timed incorrectly; something most investors are very concerned about!
So, best to be mindful of your risk tolerance and ensure that your investment approach is consistent with it to help ensure you will achieve your investment goals.