Canadian and U.S. stocks are in the midst of an eight-year bull market and investors are understandably worried about the next correction or crash. In particular, investors sitting on a large amount of cash, whether from an inheritance or a recent RRSP contribution, are nervous about deploying their capital at today’s frothy valuations.
Research has shown that, since stocks are up 70-75 percent of the time, it’s best to invest the entire lump sum all at once rather than dollar-cost-averaging your way into the market over time, or worse, trying to time the market by waiting for a crash that may never come and missing out on gains along the way.
Related: When is the best time to invest?
A Vanguard paper released several years ago looked at data from the U.S., United Kingdom and Australia and compared the results of investing a $1 million lump sum with using dollar-cost-averaging (DCA) over 12 months.
“In all three countries, over rolling 10-year periods, the lump-sum strategy came out ahead almost exactly two-thirds of the time for a portfolio of 60% equities and 40% bonds. They also ran the numbers using DCA periods from six to 36 months, and various mixes of stocks and bonds, with similar results.”
But, you say, this time is different. The markets have been on an eight-year run, which can’t last forever. Plus, TRUMP! Surely it’s better to wait for a market pullback before putting our cash to work.
Investing a lump sum in 2007
Let’s go back in time to October 11, 2007. The S&P 500 closed at an all-time high of 1,562. A year later, on October 9, 2008, it closed at 899. The bottom of this historic crash wasn’t hit until March 5, 2009 when the S&P 500 closed at 683.
Had you invested a $100,000 lump sum on October 11, 2007 there’s no doubt you’d be filled with regret over the awful timing of your investment, which had lost 56 percent of its value. Indeed, it would take until March 18, 2013 – some five-and-a-half years later – for your original investment to finally reach a positive return.
Today the S&P 500 reached another all-time high, closing at 2,382. If you managed to hold on to that investment without panicking you would have seen annual returns averaging approximately 5.25 percent since that fateful October day in 2007.
Even with the worst timing in the world, investing a lump sum just before one of the biggest stock market crashes in history, you would have been okay had you held course.
I like to put my money to work in the market right away and so if I find myself with a substantial amount of cash from a contribution then I use my long-term asset allocation as a guideline and invest the entire amount at once. That means ignoring market noise and suppressing my own instinctive fear of the unknown. It’s not easy.
For those investors who simply can’t suppress their anxiety over investing a lump sum all at once, I recommend setting up a pre-determined schedule to dollar-cost-average your way into the market.
For example, if you have $100,000 to invest then put $25,000 to work right away, then another $25,000 on the same day three months from now, and so on until it’s fully invested over a 12-month period.
Investing a lump sum may be the more optimal choice but if the fear of regret is so strong that you won’t be able to sleep at night then dollar cost averaging might be a better fit from a behavioural standpoint.