Each June, on the last day of school, I’d bike with my schoolmates to Silver Lake, a swimming hole on the Croton River, north of New York City. The mercury was creeping toward summer, but the water was frigid. We had two ways to get past the discomfort: by diving from Alligator Rock or by tiptoeing in.
This situation at the swimming hole has an investment analog, how to invest a large sum of cash. All at once, according to our long-term asset allocation? Or in smaller amounts over time? (This approach is often called “dollar-cost averaging.”)
Seizing the risk premium
In newly updated research, “Invest now or temporarily hold your cash?,” we explore the costs and benefits of both approaches. Our methodology:
- Calculate the historical performance of balanced portfolios over rolling 12-month periods.
- Make an immediate investment of the lump sum at the start of each 12-month period.
- Make a systematic investment by putting the lump sum to work in 12 equal-sized monthly increments.
- Compare the returns of the immediate and systematic investments.
As illustrated in Figure 1, immediate investment has been the better strategy in about two-thirds of all observations. This finding has held true in different markets and for different mixes of stocks and bonds.
Our findings are not new. Similar conclusions have been a staple of the personal finance literature for decades. Nor are they surprising. Stock and bond returns are more volatile than cash. To reward investors for bearing this greater risk, stocks and bonds have historically paid a “risk premium.” The sooner you put your lump sum to work, the more time you have to capitalize on this expected risk premium.
Discomfort and regret
If you want to celebrate the last day of school with a splash, a cannonball from Alligator Rock is the most efficient way to acclimate to the Croton River’s icy currents. Even so, some of us wade in. We’d rather regulate our exposure to the chill, even though we’ll feel its full force eventually. This strategy helps us get off the beach and into the water.
A systematic investment plan is the financial equivalent of wading in. What if you invested a large sum in U.S. stocks at 9:30 a.m. on Black Monday, October 19, 1987? By 4 p.m., stocks had lost more than 20% of their value. Maybe you could tolerate the shock, recognizing that the stock market’s longer-term prospects remained bright. Maybe not. If regret at the sudden loss led you to abandon your allocation to stocks, you’d do lasting damage to your wealth.
Systematic investment gives investors some insurance against regret. Figure 2 quantifies the historical payoffs and costs of this insurance.
We ranked the historical returns of a 60% stock/40% bond portfolio over rolling 12-month periods and sorted them into deciles. In the two lowest-returning deciles (and the third for the United States and Australia), the average return of a systematic investment outperformed the immediate investment. The insurance paid off. In all other periods, immediate investment did better.
All at once or soon thereafter
We counsel clients to take full advantage of the expected risk premiums in their long-term allocations by investing immediately. But we also work with clients who place a high value on minimizing the potential for regret. We advise them to set up a systematic plan, limiting the investment interval to no more than a year.
On average, the return differences between the two approaches have been modest. Both ensure that the lump sum is eventually invested according to the target asset allocation. Sooner or later, everyone gets off the beach.
Thanks to Daniel Berkowitz, Christos Tasopoulos, and Maria Bruno, CFP, for their help with this post.
A note on the indexes used in this analysis
The study periods for each market were determined by the availability of reliable and consistent monthly index data. In each country, we selected the indexes deemed to best represent the relevant market.
United States. Equities: Standard & Poor’s 90 (January 1926–February 1957), S&P 500 Index (March 1957–December 1974), Wilshire 5000 Index (January 1975–April 2005), MSCI US Broad Market Index (May 2005–December 2015). Bonds: S&P High Grade Corporate Index (January 1926–December 1968), Citigroup High Grade Index (January 1969–December 1972), Lehman Brothers U.S. Long Credit Aa Index (January 1973–December 1975), Barclays U.S. Aggregate Bond Index (January 1976–December 2015). Cash: Ibbotson U.S. 30-Day Treasury Bill Index (January 1926–December 1977), Citigroup 3-Month U.S. Treasury Bill Index (January 1978–December 2015).
United Kingdom. Equities: MSCI United Kingdom Index (February 1976–December 1985), FTSE All-Share Index (January 1986–December 2015). Bonds: FTSE British Government Fixed All Stocks Index (February 1976–December 1998), Barclays Sterling Aggregate Index (January 1999–December 2015). Cash: Inferred from UK Interbank 1 Month–LIBOR (February 1976–January 1998), Citigroup World Money Market 3 Month Index (February 1998–December 2015).
Australia. Equities: S&P/ASX 300 Accumulation Index (January 1984–December 2015). Bonds: UBS Australian Composite Bond Index (January 1984–October 1989), Bloomberg Ausbond Composite Index (November 1989–December 2015). Cash: Australian Dealer Bill 90 Day Index (January 1984–August 1998), Bloomberg Ausbond Bank Bill Index (September 1998–December 2015).