As an investor with a lump sum money to put to work in the market, I have a fear that the market will dive immediately and mistime the market. The decision of lump sum vs periodic investment decision is always a tough call to make.
With the long bull run, the market’s valuation is becoming expensive and increased volatility will make it tough to invest in today’s market. On the other hand, those who sold and held everything in cash for the last 5 years have missed out on huge gains in stocks.
There are 3 options to for large lump sum cash allocations:
1. Invest the lump sum immediately
2. Wait for an opportunity for the market to have a correction to invest
3. Split the lump sum and invest periodically to spread the risk
The second choice sounds appealing to most people but the market can remain irrational for a very long time. Invest the lump sum immediately will have the highest chance of success but the third option offers best psychological and market perspective in today’s environment.
Vanguard shows that investors would do best by investing in lump sum as market tends to go up in the long term. However, the strategy does not cater to market’s valuation. The S&P 500’s CAPE ratio is around 32 times the previous 10 years’ average real earnings which represents a level around the 1929 crash and in late 1990s when the dot-com bubble crash. This means that the market is over priced. Dollar cost averaging should work better in today’s market, leading to a smoother rider and lower probability of seeing huge losses.
Introduction to 4th option – Value Averaging
Value averaging allocates more money when stock or fund is under valued and lesser money during over valued. Say you have $100 per month, one set a “value averaging path” which consist of a target amount which increases by $100 per month. In other words, one will have $100 in the account in January, $200 in February and $1200 in December. This does not mean investing $100 per month, this will happen only when stock or fund does not change value. If the stock or fund value declines, then more than $100 will be required, if the stock/fund goes up then less will be required. It is even possible that if the stock/fund value goes up a great deal, no money at all will have to be added in some months.
Furthermore, assume that we plan an investment of $3,600 over three years. Using Value Averaging, we will probably not complete $3,600 investment in exactly 36 months. If in general the markets are up, it may require another three or six or nine months to complete the program. If on the other hand, there is a bear market, then we will run out of money long before 36 months is up.
You can read more about Value Averaging in this future post here.