If markets have recently hit all-time highs, investors may wonder whether they have already missed the best returns and so ought to wait for a pullback before getting into the market. Conversely, if stocks have just fallen and news reports suggest more declines could be on the way, some investors might take that as a signal waiting to buy is the wiser course.
Driving the similar reactions to these very different scenarios is one fear: what if I make an investment today and the price goes down tomorrow?
Two Approaches for Getting Back in the Market
Some investors favor a dollar-cost averaging (DCA) approach to deploying their investment capital. Unlike lump-sum investing, in which the full amount of available capital is invested up front, DCA spreads out investment contributions using installments over time. The appeal of DCA is the perception that it helps investors “diversify” the cost of entry into the market, buying shares at prices that fall somewhere between the highs and lows of a fluctuating market.
So, what is an investor in cash to do?
If you know us at Cogent, we look to the evidence and implications for investors. Let’s compare DCA to lump sum investing for the investor aiming to generate long-term wealth.
The stock market has offered a high average return historically, and it can be an important ally in helping investors reach their goals. Getting capital into stocks, whether gradually or all at once, puts the holder in position to reap the potential benefits.
Both theory and data suggest that lump-sum investing is the more efficient approach to building wealth over time. But dollar-cost averaging may be a reasonable strategy for investors who might otherwise decide to stay out of the market altogether due to fears of a large downturn after investing a lump -sum.
Does the Level of Entering Back in the Market Matter?
Let’s take the hypothetical example of an investor with $12,000 in cash earmarked for investment in stocks. Instead of buying $12,000 in stocks today, an investor going the DCA route buys $1,000 worth of stocks each month for the next 12 months. If the market increases in value each month during this period, the DCA investor will pay a higher price on average than if investing all up front. If the market decreases steadily over the next 12 months, the opposite will be true.
While investors may focus on the prices paid for these installments, it’s important to remember that, unlike with the lump-sum approach, a meaningful portion of the investor’s capital is remaining in cash rather than gaining exposure to the stock market. During the process of capital deployment in this hypothetical example, half of the investable assets on average are forfeiting the higher expected returns of the stock market. For investors with the goal of accumulating wealth, this is potentially a big opportunity cost.
Exhibit 1 Highs and Lows Average annualized compound returns after market highs and declines, 1926–2019
Past performance is not a guarantee of future results.
Despite the drawbacks of dollar-cost averaging, some investors may be hesitant to plunk down all their investable money at once. This often times can be an emotional decision based on fear. We say, look to the evidence.
One other piece of information the investor is ignoring is that a well-designed portfolio contains so much more than just the great companies of the S&P 500. If it was built using evidence-based investing, it should be globally diversified, owning not just the largest US companies like those in the S&P 500. It will also hold US and international small and mid-capitalized companies from around the world. It will possibly hold alternatives such as global real estate, natural resources, reinsurance, short and intermediate bonds.
While the prices of the largest growth companies in the US may have fallen or rallied, the other components may not have participated to the same extent. It is possible the expected returns for the other asset classes may be higher due to investors not bidding prices up as high or driving them lower on the way down as large US companies. The portfolio is not just the largest companies in the US, in other words.
We empathize with those who feel they should be reacting to ongoing news and paralyzed on what to do next. But our advice has always been based on scientific evidence, not on our opinion (or others) about the market’s next moves.
Time-tested, peer-reviewed evidence-based investing does not offer perfection. Nothing does. But it is the most reliable guidance available to us. And while the particulars of current events are always at least a little different than what we’ve seen in the past, we standby by our evidence-based strategy.
What Can You Do to Reach Your Investment Goals?
The most successful investors were those with a financial plan and who didn’t deviate from that plan when high volatility showed up. They leaned on the experience derived from multiple decades of evidence-based investing history and research.
Investors don’t need to be able to time markets to have a good investment experience. Over time, capital markets have rewarded investors who have taken a long-term perspective and remained disciplined in the face of short-term noise. By focusing on what you can control (like having an appropriate asset allocation, diversification, and managing expenses, turnover, and taxes), investors can better position themselves to make the most of what capital markets have to offer.
If you want to achieve your long-term financial goals, you must be willing to ride through temporary declines to participate in the advance of equities of the world’s companies over the long term.
Don’t leave your financial future to chance. You have spent your entire life working hard and accumulating the wealth that is the foundation of your life now and to come.
At Cogent Strategic Wealth, we offer clarity through the chaos. We help high-achieving individuals develop clear goals for securing their financial future. Let us help you navigate the current financial crisis and come out the other side.
Schedule a consultation today and let the team at Cogent Strategic Wealth work with you to create a plan to help you achieve your financial goals.
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In US dollars. New market highs are defined as months ending with the market above all previous levels for the sample period. Annualized compound returns are computed for the relevant time periods subsequent to new market highs and averaged across all new market high observations. Declines are defined as months ending with the market below the previous market high by at least 10%. Annualized compound returns are computed for the relevant time periods after each decline observed and averaged across all declines for the cutoff. There were 1,127 observation months in the sample.
January 1990–present: S&P 500 Total Returns Index. S&P data © 2020 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. January 1926–December 1989; S&P 500 Total Return Index, Stocks, Bonds, Bills and Inflation Yearbook™, Ibbotson Associates, Chicago. For illustrative purposes only. Index is not available for direct investment; therefore, its performance does not reflect the expenses associated with the management of an actual portfolio. “One- Month US Treasury Bills” is the IA SBBI US 30 Day TBill TR USD, provided by Morningstar. There is always a risk that an investor may lose money.
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