One of the biggest challenges investors will face is the question of timing – “If I have a significant amount of cash, when is the best time to invest it?” Investing just before a market crash can lead to regret. At the same time, holding cash in a rising market can be an expensive proposition. Holding cash while stocks rise can be disappointing in its own right. So, what can an investor do to balance potential regret in a falling against the potential for lower returns?
One strategy an investor may use to potentially limit their timing risk is known as dollar cost averaging. Dollar cost averaging entails investing a large deposit over time in multiple installments. This strategy can help to limit regret in falling markets. By not investing the full lump sum immediately, the full portfolio is not exposed to market fluctuations until all installments in the strategy are invested. That can help to limit the risk of regret if the market falls during the early stages of the process. During rising markets, however, the strategy may have a cost to investors in the form of lower returns. Because the S&P 500 has risen on average since 1926 (source: Morningstar), investing into the market incrementally instead of being fully invested has tended to cost investors some of their return.
In a recent study we conducted, the average difference in return to be as low as 0.7% for a 3 month dollar cost averaging strategy to as much as 9% for a 24 month strategy. In this study, we tested dollar cost averaging strategies lasting between 3 and 24 months and found that they tend to underperform lump sum investing on average. The longer the strategy lasted, the larger the average underperformance has been historically. The full study can be found here.
So, the decision to invest incrementally is a decision driven by the competing regrets of incurring market losses soon after making an investment versus being underinvested in a potential bull market. In determining what an investor would regret more, he or she should consider:
- Risk tolerance – A more risk averse investor may find more comfort in investing incrementally.
- Existing investment portfolio – Is the entire portfolio getting invested today, or is a relatively small deposit being added to an existing portfolio?
- Current market conditions – A more volatile environment may trigger more regret risk for an investor, so dollar cost averaging may be helpful in managing regret.
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The S & P 500 Index: The S&P 500 is an index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe. Each constituent in an index is weighted by its market-capitalization, as determined by multiplying its price by the number of shares outstanding after float adjustment.
Important disclosure information
Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.
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