What’s the Best Strategy For Investing a Large Amount of Cash? (EP.117)

0:28We all need to make smart decisions with our money. than the one we ultimately chose. It's particularly easy to see the alternatives after the fact when you're an investor. Investing is also highly quantifiable, which can lead us to believe there's always an objectively optimal decision out there. And knowing that there's an optimal choice, as well as the opportunity for things to go wrong, that leads many investors to put a lot of pressure on themselves, which I find to be particularly prevalent at times when an investor has a large amount of money that they plan to invest. Almost every time I'm working with someone in this situation, they want to know when is the best time to invest that cash.

1:06The fear in these situations is that you invest a large sum of money at a market peak and experience a severe downturn right out the gate. The degree of regret in such situations is pretty significant because with the benefit of perfect hindsight, you could have avoided a large loss and invested your cash at a meaningful discount instead. As with any investment decision, there will always be a best or optimal choice after the fact. But the only rational way to make decisions about an inherently unknowable future is to use probabilities. So in this episode, I'm going to share the data and probabilities that support the notion that when you have a large amount of money to invest, investing the entire lump sum at once is the mathematically superior choice to dollar cost averaging.

1:53Now, to be clear, I think that systematically dollar cost averaging is the best approach to investing your regular savings, but it is suboptimal when considering a large sum of money, whether that money has been accumulated over time, been acquired via inheritance, or you have some sort of capital event like selling a business, exercising stock options, and even things like earning a bonus or receiving deferred compensation. So let's start with the most basic data point. The stock market is up far more often than it's down. In fact, the S &P 500 had positive returns in over 75 % of rolling 12-month periods from 1926 to present.

2:33The frequency of those positive returns jumps to 88 % when you're looking at all rolling 5-year periods and 94 % when you observe rolling 10-year periods. The takeaway here is that unless you need that money you're investing sometime in the very near future, the likelihood the market will be higher a year from now is very good. So investing all at once is likely to be a winning strategy. Now, there are two common concerns people tend to have when presented with this information. The first is in periods when the market is near or at all-time highs. But you might be surprised to learn how well markets have performed after hitting an all-time high.

3:12In the show notes at thelongterminvestor.com, I've shared a graphic from Dimensional Fund Advisors that shows the average annualized returns for the S &P 500 after new market highs going back to 1926. And when you look at what happens in the one year after an all-time high, the average annualized return is 13.7%. When you look ahead three years after a market high, the average annualized return is 10.6%. And when you look five years ahead, the average annual return is 10.2%. So generally speaking, the data of what returns are like after an all-time high are pretty good. And that shouldn't be at a deterrent from investing a lump sum all at once.

3:56The other concern people have when faced with historical probabilities is what I refer to as the crisis of the day. Basically, that there's always something to worry about. And there's another chart from Dimensional that I've shared in the show notes at thelongterminvestor.com that shows decades worth of news and financial commentary that could easily deter someone from wanting to invest a large amount of cash all at once. But remember, risk and uncertainty about the future are the costs of higher expected returns that stocks provide. And the graphic I share does a nice job of highlighting that when you look beyond the concerns of today, you unlock the long-term growth potential of stock markets.

4:36Of course, as we go through this historical data, the allure can still sometimes be intoxicating, just this idea that you buy or sell at the right moment. So I would like to share some research published by Charles Schwab in 2021 that looks at hypothetical performance for five different investors over a 20-year period ending in 2020. Each hypothetical investor receives$2 ,000 at the start of each year. The first investor has perfect market timing such that the$2 ,000 is invested at the low point for the S &P 500 of each calendar year. The second investor invests immediately on the first trading day of the year.

5:16The third investor uses dollar cost averaging, so they divide up that$2 ,000 allotment into 12 equal portions, which are then invested at the beginning of each month. The fourth investor has perfectly bad timing, meaning that the$2 ,000 is invested each year at the highest closing level for the S &P 500. And the final investor just leaves their money in cash waiting for a better opportunity to invest, always convinced that lower stock prices are just around the corner. Naturally, the best results belong to the investor that is the perfect market timer, which finishes with just over$151 ,000. But that perfect outcome wasn't much better than the next best performer, which was the investor who immediately invested the$2 ,000 on the first trading day of each year.

6:02In fact, perfect market timing over a 20-year period only resulted in $15 ,920 more than investing immediately. And for what it's worth, the next best performer was dollar cost averaging, which trailed the immediate investor by just$615. As you'd expect, the investor with the perfectly bad market timing, the one that always invested at annual market peaks, trailed the perfect market timer, the immediate investor, and the dollar cost averaging investor. But the most important takeaway is that the investor with the absolute worst market timing still ended up with nearly three times as much as the investor that stayed in cash.

6:42Now, it's easy to look at data like this and assume it's cherry-picked or time-period dependent, but that's not so. The researchers at Charles Schwab ranked these different investment strategies over 76 rolling 20-year periods going back to 1926. And the rankings were identical in 66 of those 76 rolling periods. For those other 10 periods where the rankings were different, investing immediately never came in last place. And it was second place four times, third place five times, and fourth place only once. But the research doesn't stop there. Looking at all possible 30, 40, and 50-year time periods starting in 1926, there are only a few instances where investing immediately isn't the second best outcome to perfect market timing.

7:28So here are the few takeaways I want to leave you with from this study. For starters, if you're tempted to wait for the best time to invest in the stock market, the benefits of doing so, assuming it were even possible to time correctly, they just aren't that impressive. Remember, the perfect market timer in this study finished with just over$151 ,000 compared to the investor that immediately invested each year and finished with just over$135 ,000. Knowing that it's nearly impossible to accurately identify market bottoms on a regular basis, the extra$15 ,000 or$16 ,000 in that scenario isn't that much additional reward for assuming the very high likelihood that you will time the market incorrectly.

8:11So if you're sitting on cash waiting for the right time to invest, the evidence suggests that the best course of action is develop a plan that allows you to take action as soon as possible. Developing a plan helps prevent procrastination, minimize regret, and avoid market timing. Because even the worst luck with your investment timing isn't as bad as the high cost of waiting to invest. So if you receive a big bonus or inherit money or slowly build up a large cash position in your portfolio, investing the lump sum gives you the best odds of earning the most return possible. Plus, it also lengthens the amount of time you benefit from compounding.

8:49After investing the lump sum, you can turn to dollar cost averaging for future contributions to your portfolio. Because again, I think with regular savings, that is the best way to go about it. Now, at the end of all this, if you're still feeling uncertain about the choice to invest a single lump sum versus dollar cost average, one final thought exercise I'd like to share is something that I always do with clients. And I ask them to imagine how you might feel in the future about the choice you make today. So ask yourself, in 10 years, what would make me regret this decision? And what are some ways this decision could lead to bad outcomes?

9:25And how would I feel in those scenarios? I think if the data isn't speaking to you, sometimes taking this more introspective approach can at least help you arrive at a decision that makes your investing experience a positive one. As always, you can find links and resources at the long-term investor.com. Thanks as always for listening and to long-term investing. Thanks for listening to the long-term investor podcast. To access free financial resources and submit questions to be answered on the show, visit the long-term investor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan.

10:13This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.