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Lump Sum vs. Dollar Cost Averaging

A reader writes in to ask:

How would you advise someone with a lump sum to invest for a 15-20 year time horizon? It’s really hard for me to invest a lump sum in this current environment, when tomorrow I could wake up and have lost a substantial portion of my investment. Is it advisable to dollar cost average into the market over a period of time in order to slowly switch into one’s appropriate asset allocation?

I chose to adopt passive investing with an asset allocation that mirrors my age so that I would not have to worry about the markets on a daily basis. Yet here I find myself STRESSING about how and when to take the plunge and invest this lump sum.

Regarding dollar cost averaging, I’ve always found this brief interview with academic finance hotshot Kenneth French to be helpful.

French’s position — which I agree with — is that, from a technical standpoint, if you know your ideal asset allocation, it’s usually best to switch to that allocation as soon as possible rather than use any other (and therefore non-ideal) allocation for any period of time.

From an emotional/psychological standpoint though, dollar cost averaging is less frightening for many people than investing the entire lump sum all at once. And the expected return you forgo by dollar cost averaging over a few months is relatively slim.

Is Your Asset Allocation Appropriate?

I think it’s worth noting, however, that if the idea of having your entire portfolio invested according to what you think is your target allocation causes you to experience the degree of stress that you indicated, then perhaps that shouldn’t be your target allocation at all. Perhaps your target allocation should be more conservative.

Remember, the “age in bonds” rule of thumb is just a rough guideline. It often makes sense to adjust it one way or the other based on an individual investor’s needs.

Stock Market Volatility is Normal

Finally, I think it’s also worth noting that, if measured by monthly or annual returns, the market hasn’t actually been significantly more volatile over the last 10 years than over the previous 30. This isn’t to say that the market hasn’t been volatile. It has been. But that’s normal.

And while the recent market volatility has been accompanied by a whole list of frightening economic events, that’s normal too.

I think the best approach is to find an allocation that you could use today (without having to coax yourself into it) that would let you sleep well at night even with an unpredictable market and frightening economic news.

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  1. Thanks Mike – such good advice! The interview and link to stock market volatility were really interesting.

  2. Thanks for the post Mike~ This is something I have been pondering myself as I await the sell of some company stock that will leave me with a decision to either DCA or Invest all at once. I ran this poll on the bogleheads site awhile pack

    The results were split between between the two, and I found LIVESOFT reply to be very interesting, and one I am considering.

    “by livesoft » Sun Apr 17, 2011 3:32 pm
    I’d invest 31% into bonds right away because that’s my asset allocation for bonds. Then I’d invest half of the remainder into equities. That would leave me with 34.5% that I would dollar cost average into equities over the next 10 months. The money not in equities but designated for equities, I would put in a short-term bond fund such as VFSUX, VCSH, or VBIRX. However, if a really bad day happened, I might exchange into equities before the market closed that day.

    So I would expect to have the windfall all invested in 8 months or so since a really bad day is bound to happen by then.”

  3. OZAR,

    I can’t say that I really like LIVESOFT’s advice for two reasons:
    #1 Bond funds can go down too- they are less volatile but you could still be buying when your bond prices are higher than they would be averaged over a few months.

    #2 It isn’t very systematic- How do you define the “bad day”? What happens if you hit the “bad day” only after the market has had a lot of steady increases? On the “bad” day should you invest it all? What if there is another bad day real soon? It sounds like trying to time the market to me and that is hard thing to do.
    If I was going to ease into the market I would take a more systematic approach: Start with a high cash allocation pick the bond and stock targets so that the money not in cash has the final desired asset allocation . Each month lower the cash allocation systematically. Raise the stock and bond allocation targets so that the money in not in cash has the final asset allocation.
    This system is very deterministic each month is a rebalance determined by the allocation targets and prices. It removes the risk of buying at a market high (and the benefit of buying at a market low)- which is the point of easing into the market right?
    -Rick Francis

  4. Dave and OZAR, I’m happy to hear you enjoyed the article.

    Rick, when livesoft from the Bogleheads forum uses the term “really bad day” he does actually mean something specific, as defined here.

  5. While the lump sum DCA may or may not be a book definition of market timing, I look at it as more behavior finance thing. If I lived in the investing wind tunnel, I would like to think I could just invest it all according to my IPS and move on, and maybe I will.

    I wrote my IPS, I read my IPS, I stick to my IPS – but then comes along a lump sum that makes one’s mind begin to re-think your own plan, and will I stick to the IPS or do something else? Lump sums do not come around very often, and the behavior fear of screwing it up is REAL, and I can find some comfort in some type of DCA it into the market.

    Before doing anything, I will consult with a few fee-only adviser’s and make the choice that I am most comfortable with (risk).


  6. I’ve read quite a few investing/personal finance blogs and I keep coming back to this one as the best. Another reason why with this post. Excellent post…thanks Mike!

  7. I have always used dollar cost averaging to invest, including a monthly payment into my Vanguard Roth IRA which, at the end of the year, totals $5,000 contributed. However, for the last couple years, I decided, for some unknown reason, that since I have the $5,000 available at the beginning of the year and I know I’m going to contribute that much throughout the year, I might as well deposit all of it Jan 1. Am I making a mistake and should I switch back to the monthly contribution plan?

    (Actually, what I really do is transfer $5,000 from my Vanguard Prime Money Market on Jan 1 to my Vanguard Roth IRA. Then I make automatic deposits from my paycheck of $417/month back into the Prime Money Market, so at the end of the year the money market is whole again. Also, there’s $40,000 in the money market [emergency money], so it’s not like I’m seriously depleting that account.)

    Thanks, a newbie

  8. Hi Anne.

    If you have the money available on January 1, I’d put it all in that day. I don’t see any particularly good reason to give up any expected return by waiting to invest the money. (The exception, as described above, would be for people who find it emotionally easier to spread it out over time. But that doesn’t sound like it’s the case for you.)

    In fact, that’s what my wife and I do with our own money: In years when we have the cash available on January 1, we go ahead and max out our Roths for the year right away.

  9. Many thanks. It’s reassuring to know I’m not doing something stupid!

    Enjoy your blog and loved “Can I Retire?”

  10. Anne,

    I’m always happy to answer questions. And it’s great to hear you enjoyed the book. 🙂

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