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With stocks on a tear, investors might be wondering whether the market is at a peak or about to enter a tailspin. This is a particularly problematic question for people with a lump sum of cash to invest.
The key to getting invested – whether that’s when markets are rising, falling or doing nothing much – is to have a plan. A written plan defines your asset allocation, types of investments, and your investment time horizon.
If you – like most people – don’t have an investment plan, and you are sitting on a lump sum of cash right now agonizing over what to do, here’s how to make a decision.
You have three options: invest it all right now (lump-sum investing), break it into chunks and invest it over time (dollar-cost averaging), or wait for the market to decline and then invest it (market timing).
If maximizing your returns is your top priority, lump-sum investing has historically been the right choice. However, investing isn’t just about returns – it’s also emotional. If you think you’ll feel stress and anxiety if you invested before a market downturn, then dollar-cost averaging (DCA) is the better choice for you. Market timing is precarious, and not a good option for most people.
Lump-sum investing wins financially
Multiple studies over the years have shown the putting a lump sum of money into the stock market beats investing in chunks over time. One study by Benjamin Felix at PWL Capital, analyzed historic stock market data, and it showed that 71 per cent of the time, the value of the money invested into the U.S. stock market in a lump sum was worth more after 10 years than money invested using DCA. This study used data between 1926 and 2020, so it captured a lot of market cycles. Results are similar for other markets, including Canada.
Averages only tell part of the story, though – what about investing in a market like we are in today, where valuations are high? The study shows that even in this kind of market, lump-sum investing beats DCA. When investing in the U.S. stock market, you have a 64-per-cent chance of doing better with lump-sum investing than with DCI when the stock market is expensive.
Dollar-cost averaging wins emotionally
Investing should never cause you angst. If you have an investment plan and the right asset allocation, you should feel confident and comfortable no matter what’s happening with the stock market. But let’s be real: investing a lump sum of cash now only to see your investment plummet shortly thereafter would be really hard to take.
DCA can alleviate your buyer’s remorse. The key to this strategy is to have an investment schedule. Decide how many portions you want to break your money into and how often you will invest it. This could be 1/12th invested each month over the next one year, one quarter invested every six months over two years, or any allocation that you can commit to. Put the “buy” dates in your calendar and no matter what happens to the stock market, invest the money on those dates. No humming and hawing.
Market timing rarely wins
Keeping your money in cash and waiting for the market correction to happen before investing is the least-favoured option. For one thing, you have to get the timing right. Investing at the precise bottom of the market is impossible to do – if someone gets it right, they are merely lucky.
This approach can also result in constantly watching the market, obsessing over news headlines, and essentially having it take over your life. If you’re into that, great, but know what you’re getting yourself into with this strategy.
You also risk missing out on a rising market. While your money is earning a paltry return sitting in a cash investment, the stock market could be marching higher, leaving you out of the game.
If you feel strongly about waiting for a market correction, then at least put some parameters in place. You could set a downside target and commit to investing when the market gets there. For example, you could say that if the S&P 500 goes down 20 per cent, that’s your buying point. Of course, you could be waiting a long time, so you might want to also put a time limit on this.
Just know that even this strategy – investing after a 20-per-cent market decline – has historically been the inferior choice versus lump sum investing, which wins 54 per cent of the time.
When it comes to getting your money invested in the stock market, you need to decide what approach you can stomach. Make a decision and act on it.
Anita Bruinsma is a Toronto-based certified financial planner at Clarity Personal Finance.