Many of my clients ask me the age-old question of whether they should invest cash all at once or dollar-cost average over time. This decision can have a significant impact, so I’ll lay out some key considerations I review with my clients.
The goal of dollar-cost averaging is to spread out investing in riskier assets to achieve a lower average purchase price. For example, if the market drops in the short term, you may be able to capitalize on discounts in equity prices. The risk here is that if the market rises, you’re not fully invested and can’t take advantage of the market’s appreciation.
My first step is to find out where the money is coming from. Is this their first time investing, or have they received a windfall from a pension payout, the sale of a business, or from an inheritance? Perhaps this money has been sitting in cash or represents investments that were moved out of the market in anticipation of a downturn. If the answer is the latter, I recommend reading a recent blog from our CIO Tim Buckley on how to approach market volatility.
Whether you’re investing for the first time or you’ve been investing for years, how do you proceed with this decision?
Identify the goal for the money
For many of us, determining why you’re investing may seem like a no-brainer, but remember that without an investment objective it’s difficult to create a plan. Clients who receive a lump-sum payout from a pension may want to earmark those dollars for long-term care, leaving money to family, or something that may warrant a different risk tolerance than their other investments. Also, if you need the money for a short-term expense, not investing at all may be the correct decision. I generally recommend that we don’t invest money if we plan on needing it within the next 12 months. In these instances, parking it in a savings account, CD, or money market may be a better approach.
Evaluate your risk tolerance
While determining the right level of risk is a key decision during the investment planning process, it’s also an important consideration if you are looking to dollar-cost average. In this case, you’re most likely concerned with a market downturn shortly after you invest. How will you manage your other investments during this downturn? Are you comfortable with the potential loss on money already invested? Risk is a two-way street, but most of us look at risk as something we can tolerate as long as the result is a net positive. In my decade-plus of working at Vanguard, I rarely receive calls from clients asking me to reduce risk because they’re making too much money! The most successful relationships I have are ones in which my clients are comfortable with the level of paper loss they may encounter before it occurs.
Make the decision
Once you’ve developed a plan for this lump sum, how do you achieve it? According to Vanguard’s research, roughly two-thirds of the time, lump-sum investing generates higher potential returns. In essence, this analysis confirms the risk-reward principle of investing. The more risk we take, the greater the potential for return, but on the downside there’s also higher potential for losses. Dollar-cost averaging delays risk by keeping more money in cash until you reach your target allocation. I understand this is an objective answer that may not resonate with all investors, so let’s dive a little further.
What I’ve found to be the best of both worlds is to invest all at once and then rebalance according to a set allocation of diversified stocks and bonds. This allows you to participate in market appreciation, but also allows you to buy low when the market drops, which is the indirect goal of dollar-cost averaging, right? On paper, this seems easy, but as the market experiences volatility, many investors fail to capitalize on these buying opportunities. The behavioral aspect of investing plays a large role in long-term returns.
It’s important to keep a holistic view when making your investment decisions. Diversification helps spread out risk with our investments, and similarly, you may already be diversifying your dollar-cost averaging via 401(k) contributions and college savings. If you find the only way you’ll sleep at night is to dollar-cost average, I generally recommend spreading it out over a period of no more than a year. In addition, I usually only dollar-cost average into stocks. In normal market conditions, the price fluctuations of bonds usually don’t offer quantifiable value for dollar-cost averaging.
No matter which approach you take, stay disciplined and stick to your plan. It will give you the best chance to achieve your financial goals.
- All investing is subject to risk, including possible loss of principal.
- Diversification does not ensure a profit or protect against a loss.
- Dollar-cost averaging does not guarantee that your investments will make a profit, nor does it protect you against losses when stock or bond prices are falling. You should consider whether you would be willing to continue investing during a long downturn in the market, because dollar-cost averaging involves making continuous investments regardless of fluctuating price levels.