Take the Plunge, or Drip by Drip?
One of the questions I am most asked goes something like this: “I have a large amount of cash to invest. Should I invest it all at once or spread the investment out over time?” Perhaps the cash comes from the sale of a business or an inheritance. Or the cash might build up over time because of concerns about the market turning bearish. It might even be the result of panicked selling.
From one perspective, the answer appears simple. Stocks have returned about 10 percent per year, versus about 3 percent for one-month Treasury bills. The reason is that stocks are riskier investments, and they are riskier every day. Every day you are not invested in stocks, you are foregoing what is called the equity risk premium, or the excess return that an individual stock or overall market provides over a risk-free rate.
Therefore, the logical answer to the question is to invest whenever cash is available. Doing otherwise will likely cause an investor to eventually buy at higher and higher prices. Unfortunately, investors don’t always base decisions on logic. In fact, the stomach (emotions such as fear) often plays a far greater role in decision making than the head (logic).
It is my experience that many investors are sure that if they take the plunge and invest all at once that day would turn out to be a high, not to be exceeded until the next millennium. This causes them to delay the decision altogether, with often paralyzing results. If the market rises, they feel that if they couldn’t buy at what they felt was too high a price, how can they buy now at even higher prices? If the market falls, they feel that they can’t buy now because the bear market they feared has now arrived. Once a decision has been made to not buy, exactly how do you make the decision to buy?
There is a good solution to this dilemma, one that addresses both the logic and the emotional issues. Investors should write a plan for their lump sum. It should define a schedule with regularly planned investments. The following are some suggestions:
Invest one-third immediately and the remainder invested one-third each of the next two months or next two quarters
Invest one-quarter immediately and the remainder spread equally over the next three quarters
Invest one-sixth each month for six months, or every other month
The important issue is writing down and adhering to the schedule, not the specific schedule itself. (With the new year, it’s a great time to create a plan or to amend an existing one.) The only caveat is that investors should not make the schedule too long, because the longer the schedule, the more likely it is that the investor will miss out on market gains.
Once investors have a written plan, they should sign it. If they have a financial advisor, they should instruct him or her to implement the plan regardless of how the market performs. This is only way an investor can be sure that the plan will be implemented. Otherwise, the latest headlines or guru forecasts might tempt the investor.
Having accomplished these objectives, investors should adopt the following perspective. If the market rises after the initial investment, they should congratulate themselves on their wise decision. They can also feel good about the profit. If the market has fallen, investors can congratulate themselves for being smart enough to have avoided investing the entire amount, and they can feel good about the opportunity to now buy at lower prices.
Either way, the investor wins from a psychological perspective. Since emotions play an important role in how investors view outcomes, this is an important consideration.Once investors are convinced that a gradualist approach is the correct one, it is important to ask themselves: “Having made your initial investment, do you want to see the market rise or fall?” The clear logical answer is that they should root for the market to fall so can buy more at lower prices. Aren’t we all taught to buy low?
This commentary appeared January 03 on Larry’s blog at CBSNews.com.
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