Maybe you’re selling your share of a business, real estate, or about to receive an inheritance. Given the runup in asset prices – from stocks to real estate to private equity – you could end up with a windfall or “unexpected good fortune” — literally. The not-so-pleasant conundrum: How do you invest that money when you fear that markets are at all-time highs?
Waiting to invest until after asset prices drop significantly is a recipe for frustration, not to mention loss of purchasing power. Many waiting on the sidelines last year, for example, were left in the dust when the S&P 500 index rebounded after March and kept chugging along despite the global pandemic: 2020 gains were over 18%!
The stock market will lose ground at some point, but no one really knows when. Therefore, the wisest course is to invest a significant amount of new profits/gains in a diversified portfolio, assuming you won’t need that money during the next three to five years.
No doubt, the thought of putting thousands or millions of dollars into the markets all at once can be daunting and paralyzing. “I have all this money,” you might say to yourself, “why not play it safe and do nothing for a while?” While this type of thinking seems prudent, it is not. It can lead to months and even years of indecision and missed growth opportunities.
One good, common-sense solution: Invest chunks of the capital incrementally through what we call “averaging-in” (aka dollar-cost-averaging). Commit to putting part of the money into a diversified portfolio in equal amounts, at regular intervals, regardless of what the market is doing. Averaging-in is how 401(k) accounts are typically funded but this can apply just as well for investing windfalls over a specific period of time.
Say you netted $5 million from a real estate transaction, none of which you will need for at least three years. Instead of investing that amount all at once, add $500,000 per month to your portfolio over the next 10 months. During that time, if the market drops you will feel better because you’ll be buying during the drop, resulting in lower prices per share over time.
Why Averaging-In Works
Takes the emotion out of investing. By investing the same (or roughly the same) amount at regular intervals over a preset period, you reduce the temptation to time the market. When an advisor averages-in for you, as we do for some of our clients, it is much easier to stick to the plan.
Reduces short-term risk. Your average buy-in price during the investment period will often be lower than investing a lump sum right off the bat, regardless of market direction.
Timeframe Is Key
The longer you take to average-in, the more of a long-term return disadvantage you will have relative to lump sum investing. If your investment timeframe is 10 or more years, a study from Vanguard Research indicates that nearly 70% of the time you’d be better off investing a lump sum instead of dollar cost averaging. (Vanguard looked at US, UK and Australian markets from 1926 to 2011using 10-year rolling periods.)
Does that mean you shouldn’t average-in? Definitely not. Markets do not go up in a straight line, so averaging-in makes sense for many people. It seems to me that averaging-in over 12 months or through a typical business cycle probably provides better long-term results – reducing risk in the near term, while not greatly sacrificing long-term returns.
If the averaging-in period stretches beyond 36 months, however, you’re more likely to lose out on long-term returns. The money on the sidelines will be generating very little income, plus there’s more of chance you’ll be missing out on market gains as you average-in.
Regardless of what timeframe you choose for averaging-in, be sure to stick with it. Otherwise, you could end up getting whipsawed: enticed by rising prices to invest more money into the markets than you had planned and then panic selling during a market plunge.
Bottom line: With a large amount of new capital to invest, you might be less concerned about capturing the highest return than you are about the regret you might feel if you went all-in right before a market drop. If so, averaging-in can help you reduce short-term investment risk, put your money to work, and sleep easier at night.
At LNWM, we provide our clients with investment portfolios structured to meet specific needs and goals in terms of risk, return, cash flow, taxes and many other factors. But we don’t stop there. In addition to WHAT to invest in, we advise on WHEN and HOW to use those assets to achieve long-term aspirations. This can include funding a trust, direct gifts to family and charity, or setting up a foundation.