Most of the time, the market is going up, so historically the sooner you get the money in, the more it will make, but sometimes it doesn’t work that way, and you have to be willing to accept that risk or try to mitigate it somewhat with dollar cost averaging (DCA), which is where you put money in periodically over a period of time to keep you from getting all your money in at a peak, or guarantee you get an “average” price over some particular time period. This Vanguard research paper, this article by Michael Kitces, and this article by Larry Swedroe on the topic are well worth reading.
Entry-point risk
Investing a large amount in one go has entry-point risk, which is the risk of investing it all at a single point in time and then if there’s a crash right after, you face the full brunt of the risk eventuating, whereas spreading it out for instance into say 40-50% upfront and the rest over a couple of years would have the following outcomes –
- If there was a crash immediately, you faced the risk with half your money but can make up for it by buying cheap with your other half.
- If there was a crash in 1 year, you had 1 year of growth for half your money, plus still some money to buy cheap, together offsetting a lot of the loss.
- As a potential crash point moves further away, you had more invested and earning for longer to cushion the fall, reducing the impact of a crash.
Essentially it spreads out the risk.
Is this a good idea?
It depends.
For someone nearing retirement and with a significantly large lump sum relative to their retirement goal/needs, it makes a lot of sense because they have less time to recover from a possible sustained bear market during the first few years of drawdown when they are at their financially most vulnerable period.
I would be less likely to do this for someone younger and further from retirement or with a smaller amount. Instead, I’d consider setting an allocation of stocks to bonds that you’re comfortable leaving invested even if there is a crash and then invest it all into that allocation. But if you’re just not comfortable emotionally with the idea of seeing it drop soon after putting in a lump sum, spreading it out is fine as long as you’re getting more and more of it in over time so it can start earning money.
How to DCA
The main problems with conventional dollar cost averaging are:
- Leaving the yet-to-be-invested portion in cash earning nothing, as money is slowly added to the investment.
- The first half of the DCA period would have, on average, only 25% of the final desired equities invested, meaning there was not enough earnings to cushion any fall in value, which would simply push back the entry point risk.
- Adding funds over just 6-12 months is such a short time that, again, it merely pushes back entry point risk.
These issues are addressed by immediately allocating half of the desired amount to equities and the rest to bonds, fully investing the funds (with a smaller stock allocation) and then gradually increasing the stock allocation to reach the final desired allocation.
Here’s an example.
Let’s say a target asset allocation of 60/40 (60% stocks and 40% bonds) was the goal, and we wanted to DCA into equities over two years.
This could be done by investing. it all right away, but with 40% stocks and the remaining 60% in bonds, and then glide the allocation of stocks up by around 1% a month. After 20 months, it would reach the target allocation.
E.g.,
| Month 0: | 40/60 |
| Month 1: | 41/59 |
| Month 2: | 42/58 |
| … | |
| Month 19: | 59/41 |
| Month 20: | 60/40 |
If the market dropped and pushed the actual allocation out by more than 5% from the target allocation, or if the increased target allocation resulted in the actual allocation being out by more than 5%, it would be rebalanced to the desired allocation. This way, if there is a market drop, we would be selling more bonds to buy equities at a lower price, taking advantage of the fall in equities, which is one of the biggest failings of dollar cost averaging.
Further reading on lump-sum investing and managing a windfall
Managing a windfall – Bogleheads
6 Things To Consider When Investing A Lump Sum – Rick Ferri
The Lump Sum vs. Dollar Cost Averaging Decision – A Wealth of Common Sense