It must seem like a dilemma for the elite in the Boulder County bubble, but sudden money happens more often than you’d think. Locally you may think of stock equity in a quickly growing company. Whether it’s Pfizer’s $11 billion acquisition of Boulder-based Array BioPharma or the pending IPO of Denver-based Ping Identity, we have had many successful companies get their start in our area.
Coming into cash doesn’t have to be that glamorous. Sadly, it often happens due to a death in the family. Also businesses are sold, people retire and decide they should cash out their pension (probably a bad idea!), and homeowners downsize. Say you come into funds that comprise a sizable portion of your wealth. What should you do with it apart from buying a ski chalet?
When dealing with a lump sum the first option is to invest your windfall all at once. Another common choice is called dollar cost averaging or periodic investing, that is making equal purchases over an agreed upon interval, say every month for year. But which is the best option given today’s market conditions and your personal financial situation?
Studies about dollar cost averaging usually come to the same conclusion. On average you will end up with a higher balance in your portfolio if you invest your funds as soon as possible. Researchers at Vanguard concluded that investing a lump sum in a 60 percent stock and 40 percent bond portfolio end up doing better on average than those who invest equally every month over a year.
I don’t watch much TV, but just enough to encounter Captain Obvious commercials. I think we can bring him in to support some conclusions of the Vanguard study because they are readily apparent. The stock market has gone up in value about 70 percent of the years and 60 percent of the months over its history. On average a lump sum must perform better than a periodic strategy. Sure enough the study confirmed that a lump sum approach resulted in higher performance about 68 percent of the time.
But if the sudden money can make a significant difference in your financial situation, the question is not just about the average result. It’s also about the worst case. We don’t want to invest everything right before a bear market, which we can easily imagine as we’ve seen two historically bad ones in the last fifteen years. Behavioral finance has demonstrated we hate to lose much more than we like to win. If that’s the truth, to optimize our happiness then we should place greater weight on the risk of losing versus the upside of a gain.
Let’s say you have inherited $200,000. Would you feel as joyous with a $20,000 gain as you would suffer if it declined to $180,000? If there’s more regret in your heart, consider investing in equal portions over 12 to 18 months. Without getting too much into the data, studies have found when you space investments out over longer periods than that, the odds are much higher that periodic investing will be a losing strategy. A Vanguard study looked a 36-month periodic investment strategy for a balanced portfolio and concluded that the lump sum approach beat it 92 percent of the time. Those odds are too much to overcome.
One final thought when investing a windfall over time: make sure when you do this that it’s carried out without your manual intervention each time. Most brokerage and mutual fund companies have this feature. Otherwise when the preordained investment date comes around you’ll be tempted to ponder if that day is the right one to invest, and may find yourself out of the market for years waiting for the perfect moment.