Dollar Cost Averaging vs Lump Sum Investment
3 months ago JCprojectfreedom 0
As an investor with a lump sum money to put to work in the market, I have a fear that the market will dive immediately and mistime the market. The decision of lump sum vs periodic investment decision is always a tough call to make.
With the long bull run, the market’s valuation is becoming expensive and increased volatility will make it tough to invest in today’s market. On the other hand, those who sold and held everything in cash for the last 5 years have missed out on huge gains in stocks.
There are 3 options to for large lump sum cash allocations:
1. Invest the lump sum immediately
2. Wait for an opportunity for the market to have a correction to invest
3. Split the lump sum and invest periodically to spread the risk
The second choice sounds appealing to most people but the market can remain irrational for a very long time. Invest the lump sum immediately will have the highest chance of success but the third option offers best psychological and market perspective in today’s environment.
Vanguard shows that investors would do best by investing in lump sum as market tends to go up in the long term. However, the strategy does not cater to market’s valuation. The S&P 500’s CAPE ratio is around 32 times the previous 10 years’ average real earnings which represents a level around the 1929 crash and in late 1990s when the dot-com bubble crash. This means that the market is over priced. Dollar cost averaging should work better in today’s market, leading to a smoother rider and lower probability of seeing huge losses.
Introduction to 4th option – Value Averaging
Value averaging allocates more money after periods of positive performance and less money after periods of poor performance. For instance for buying into a falling market, we set the dollar amount of portfolio increase desired for each month as $10k, if the portfolio starts with $10k as well, the first month we buy in $10k. If in the 2nd month, the portfolio decreases in value to $18k (2k depreciation), we will buy in $12k worth of stocks for that month to “play catch up”. Likewise for buying into a rising market, portfolio starts at $10k, first month we buy in $10k. If in 2nd month portfolio increases to $22k (2k appreciation), we will buy in $8k worth of stocks.