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So, maybe you’ve recently inherited some money. Perhaps, a loved one passed away, and you’ve been granted control of the estate, or maybe you were a beneficiary in someone’s will. Regardless of the circumstances, you’re now sitting on a pile of cash or liquid assets that you want to put to good use. How should you go about investing it, putting that money to work to, hopefully, bring in more money? One of the most common questions that come up in this situation is, “Should I invest the money all at once or spread out my investments over time?”
As an investment advisor, I have come across this question again and again. So, let’s take an objective look at it and logically figure the best course.
Dollar-Cost Averaging
People who think about gradually investing their money over time often consider a strategy known as dollar-cost averaging. So, what is dollar-cost averaging (DCA for short)? Dollar-cost averaging simply means that you invest a set amount of money at regular intervals, such as monthly. The dollar-cost averaging part means that you invest the same amount of money every month or buy the same number of shares every month, regardless of whether your chosen investment—a stock, a mutual fund, or an ETF—is going up or down in price. By doing that, you’re basically buying the investment at what the average price is over your investment time frame.
Part of the appeal of dollar-cost averaging is that it’s a simple strategy to employ. You’re not spending time endlessly analyzing to try to decide, “Is this a good price to buy this thing? Is it high, is it low, is it going up –going down?” It’s also appealing because it helps you develop the habit of regularly putting money into investing.
But there’s a problem with dollar-cost averaging: historically speaking, it doesn’t seem to work very well. More than half the time, it turns out that you’d have been better off, meaning more profitable, if you’d invested a lump sum all at once.
How Dollar-Cost Averaging Plays Out
There are three ways that the dollar-cost averaging investment strategy can play out.
Let’s start with the most favorable scenario: the asset initially falls but eventually rises in price. You’ve invested a set amount of money or bought a set amount of shares, on a regular, scheduled basis, in a stock or other asset. During a lot of the time you’ve been making these regular investments, the asset has been going down in price. So you’re feeling pretty smart and everything seems to be going your way. That also means that as the price has gone down, you’ve bought more and more at a cheaper price. Now, if at any point in the future, the asset’s price rises above the highest price you’ve paid for any of your shares, then your DCA strategy is going to pay off nicely.
For example, assume that you bought shares of a stock on your regular monthly investment schedule for a period of one year. In the beginning, the price dropped, so for your first three buys, you might be buying at
$100 a share
$95 a share
and $90 a share.
After going down for another four months, the asset then starts to rise in price. Your last three buys of the year might be at
$95 a share
$100 a share
and $110 a share.
Your average cost turns out to be $88.75 per share. With the asset currently valued at $110, on average, you’re profitable to the tune of $21.25 per share. Obviously, that’s a more profitable position than if you had just bought all your shares at the same time at the price of $100—which was the market price when you started out.
But what if the price just keeps dropping and never recovers to a level above your first buy price? In this second possible scenario, sure, you’re getting cheaper and cheaper buy-in prices, but the investment is basically a losing one, and by continuing with your DCA strategy, you’re really just throwing good money after bad.
The final possible scenario for your DCA strategy is one where the asset steadily rises in price from when you first start buying. This sounds good, right? Your investment is obviously making money. However, you missed out on some potential profit because you’re paying higher and higher prices for your shares. You’d have done better buying all your shares at once in the beginning.
The best takeaway from considering dollar-cost averaging is this: stock prices and market indexes rise and fall. They go up in price at times, and at other times they go down in price. Therefore, no matter what your investing strategy, one of the most helpful things you can learn is the ability to accept the market’s changing fortunes and to realize that you’re not always going to buy or sell at the very best price, no matter what strategy you use. However, the evidence of history is very strong that if you follow a solid, well-thought-out investment strategy, the odds are in your favor that over the long run, your investments will prove profitable for you.
Opportunity Cost
Another aspect to consider when you’re thinking about investing all your money at once or spreading out your investments over time is the concept of “opportunity cost”. Opportunity cost simply means that when you commit your money to investment “A”, then you’re missing the opportunity to profit from investments “B”, “C”, “D”, and so on.
For example, you might invest all your inherited wealth in a real estate venture that offers you a 10% annual return. Not bad, not bad at all. But what if that real estate deal isn’t a liquid investment? What if it requires you to commit your money for a minimum of three years? Then, what if just a few months after you invest in that deal, another investment opportunity comes along that would have given you a 15% annual return? Unfortunately, you can’t take advantage of that opportunity because all your investment capital is already tied up in the real estate deal. That’s “opportunity cost”.
Taking potential opportunity cost into consideration, you may want to avoid investing all of your money at once or, at least, avoid very illiquid investments. Instead, keep some of your money in reserve so that you have money to put into another and better opportunity you might run across six months or a year or so down the road.
Do It Your Way
In the end, how you invest your money is up to you, and that’s the way it should be. You have to decide what your financial goals are, what your risk tolerance is, and you have to be realistic about what type of returns you can expect to make. Finally, you have to choose what investment strategy you like and are most comfortable with. For some people, investing all the money upfront is the way to go. For others, spacing out investments over time and holding some of their cash in reserve will be more appealing. The final decision comes down to you, the investor. It’s a good idea to speak with a financial advisor and other professionals, who can help you choose an investment strategy that fits into your overall financial planning and will best serve your personal financial wants and needs.
If you want to take a more in-depth look at the dollar-cost averaging strategy, check out Dan Moisand’s article in MarketWatch, “I inherited money. Should I invest it all at once? Or space it out?”
Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. There are no investment strategies that guarantee a profit or protect against loss. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however, their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by the radio show.
