March was a challenging time for investors as we entered our first bear market since 2008. While most investors did not sell stocks during the decline, if history is any guide, many of you did. The financial research company Dalbar releases an annual study of investor behavior that regularly concludes that individual investors largely underperform the market indices. This means many of you are holding safe assets such as short-term bonds waiting for the right time to invest. Perhaps you didn’t sell stocks, but find yourself with “sudden money” because you’ve sold your house or received a bonus from work.
Most investors realize that holding only cash is not the long-term path to achieve financial independence. But in today’s volatile market, how should we move from a defensive posture without buying stocks at the top? Here are three strategies to get you invested.
Invest it all at once. Investing your cash all at once will result in the highest returns on average. In the last 20 years we’ve experienced two severe bear markets not counting this year. In spite of these poor markets, the S&P 500 index has increased 15 out of the last 20 years.
A study by Vanguard concluded immediate investors with a 60 percent stock and 40 percent bond portfolio outperformed more gradual investing strategies in over two thirds of 12-month periods studied going back to the Great Depression. The average net benefit of investing at once was about 2.4 percent versus investing cash every month.
Dollar cost averaging. Dollar cost averaging is the process of moving cash into your desired portfolio on a regular basis, say every month over a year. Most of us do this when we contribute to our retirement plans. This makes sense as we invest our money as we’re paid. But the idea that we have a lump sum of cash and deliberately delay investing is very different.
With lower average performance, is there anything to recommend it? Perhaps the biggest advantage is that you are more likely to stick with this strategy. Most investors have only one or two times in their lives when they come upon sudden money. If you invest those funds all at once and are unlucky enough to do so at a market top, you’ll most likely experience considerable regret. If you invest your cash on a systematic basis, you’ll still cringe if the market declines but will know you will get a relative bargain on your future stock purchases.
Value averaging. This approach is less common and more challenging to implement. It’s similar to dollar cost averaging as you’re investing your cash over time. The difference is that with value averaging you direct more cash into the investments that have not performed as well. If stocks have declined over the last month, you will invest more money in that category.
Value averaging doesn’t have a lot of studies behind it with the notable exception of Michael Edleson’s book dating back almost fifteen years. Its complexity requires investors to evaluate asset prices and tweak new investments every month with an iron gut in the face of market volatility. This may be too much to ask.
Which of the three strategies should you use? The lump sum approach pays off in most markets, with the potential of investing it all at the wrong time. Dollar cost averaging could be the best way to put a plan in place that you will implement. It won’t do as well as the lump sum on average, but you will be better able to stomach market declines. Finally, value averaging holds great promise if you can find a way to implement it without losing heart as it requires you to invest more in the market when it has declined.
David Gardner is a Certified Financial Planner practicing in Boulder County. The opinions expressed by the author are his own and are not intended to serve as specific financial, accounting, or tax advice.