A common question SMI has fielded over the past 30 years is what is the best way for a person to invest a new lump sum amount. Specifically, what most people are wondering is whether it's better to invest it all at once, or spread out their investing over time using some type of dollar-cost-averaging (DCA) approach.
This question is trickier than it seems because there are two aspects to the decision. There's the strictly financial aspect and the emotional aspect. As someone recently remarked (I'd give them credit but I don't remember where I saw it), "What works in a spreadsheet doesn't always work at the kitchen table." Very true.
SMI's typical response to this dilemma, particularly if a person is concerned about a market drop soon after investing, has been to divide the lump sum into some number of pieces and invest them one at a time over a specific time period. So, for example, the person who just received $100,000 as an inheritance and is nervous about investing it all at once might be suggested to divide that into four equal pieces, with each quarter to be invested every other month (or at the beginning of each calendar quarter, etc.).
The point with such suggestions isn't the number of pieces or the time intervals over which to invest. It's simply to get a plan in place the investor feels comfortable with so that the person starts taking action. The alternative is inertia/paralysis, which is how people wind up three years later in the same situation saying, "I didn't invest any of it because it just never felt like a good time to do so." Using DCA to invest a lump sum isn't about improving returns, it's about reducing the size of the emotional hurdle to a level the investor can actually step over.
The cost of waiting
That advice has served many people well over the years, or so we'd like to think. However, I came across an interesting analysis recently by data analyst Nick Maggiulli titled "The Cost of Waiting" that suggests there's a better approach to investing a new lump sum. Maggiulli also recognizes the fact that there's both a practical and emotional angle to this. But instead of trying to manage the risk/emotional element by extending the time period over which the lump sum is invested, as we're doing by spreading out the investments in the DCA scenario, he argues for investing the whole amount right away — but using a more conservative investing approach to do so.
The big idea of Maggiulli's analysis is that any stock/bond allocation — from 100% Stock/0% Bond all the way down to 0% Stock/100% Bond — would have outperformed dollar-cost-averaging into a 100% Stock portfolio over the average 24-month period (1960-2018). That 24-month DCA period is longer than we would typically suggest, but the conclusion is still surprising.
The takeaway of Maggiulli's piece is that rather than waiting to invest over time, it's better to invest it all now using a more conservative approach. So if your portfolio would normally be 60/40 Stock/Bond, maybe you would invest the lump sum 40/60 (or 20/80, etc.) — whatever it takes to make you comfortable enough to actually pull the trigger and get the money invested.
This is a helpful addition to solving the "how should I invest a new lump sum" question, although there are a couple of caveats. One big issue I see with this approach is it doesn't address how a person should transition toward their optimal long-term portfolio allocation from this more conservative starting point. Maggiulli wrote the article for advisors, so it's fair that he might assume the advisor would handle that process. But for individuals implementing this on their own, it's definitely an issue to be aware of. I would imagine any benefits of this starting approach would quickly disappear if the investor stays with a more conservative allocation as a result. There has to be a mechanism to get the portfolio to the desired long-term allocation, whether that's through the annual rebalancing process, or something else.
The most important thing is to not lose sight of the ultimate goal here. Investors often struggle to take action when faced with investing a new lump sum. I would suggest that whichever approach gets them moving is the right one. It's kind of like a diet or exercise program — the best one is the one you'll actually stick with, right? So if one person finds it easier to get started by drastically lowering the riskiness of their starting allocation, while another finds it easier to start by DCA'ing into the market over time, I'd say either is acceptable. If both choices are emotionally palatable, however, Maggiulli's research indicates that investing the whole sum using a more conservative allocation has been the better financial choice a majority of the time over the past several decades.