Putting Your Cash to WorkMarch 28, 2016 10:30 am
It is not unusual for a client to call me and want to put some cash to work. “Is this a good time?” the client often asks. While I am a firm believer in investing, how I answer that question depends on the person I am talking to.
Many people find it difficult to part with their cash. After all, cash can represent hard earned dollars that have been safely tucked away in a bank. With CDs and money market accounts, one doesn’t have to worry about the stock market or what happens in China. But even the bank isn’t as safe as you might think.
Over time, it is inflation that gets to you. In recent years interest rates on CDs and deposits have rarely matched or exceeded inflation. That means you can lose buying power by keeping cash in your money market or savings accounts. In addition, most people need to earn more than inflation to meet their retirement goals.
So is this a good time to invest?
For this article, let’s assume that you have done your basic financial planning: you have set aside a healthy, liquid emergency reserve; have paid down or off the ugly debt on your balance sheet; and have earmarked the cash in question for retirement or some other longer term goal. In addition, let’s assume we are dealing with a meaningful lump sum of money. In this case, it is all about timing.
The key issue is: do you invest the cash all at once? Or do you add it to your accounts over time?
Most people are familiar with dollar cost averaging (DCA), a strategy where fixed dollar amounts of cash are invested over time at fixed intervals. Most retirement plan contributions are dollar cost averaged into 401(k) or 403(b) plans, as the participants allocate a certain portion of each paycheck to 401(k) contributions. The primary benefit of DCA is that when the markets fall, you are buying more shares for each dollar invested. (Conversely, you are buying fewer shares when prices are high.) When you buy low, you have more shares that can benefit when assets increase in value.
The other benefit to DCA is that it helps to control risk. By avoiding investing all at once, you may be able to minimize the effect of a bear market on the invested cash.
But dollar cost averaging may not be the best approach. AllianceBernstein completed a study in 2014 of investment returns for the period 1926-2013 comparing lump sum investing, dollar cost averaging and holding cash. Over that period, the study found that investing immediately into the S&P 500 returned 12.2% annually; dollar cost averaging returned 8.1% annually and holding cash yielded 3.6% return. https://blog.abglobal.com/post/en/2014/07/is-dollar-cost-averaging-the-cure-for-market-jitters.
Michael Kitces, author of Nerd’s Eye View , in his March 9, 2016 blog (http://www.kitces.com.) compared dollar cost averaging vs lump sum investing on a shorter time frame (1996-2015) with a similar result: lump sum investing outperformed dollar cost averaging 75% of the time.
The logic isn’t hard to explain. Most of the time stocks go up. And getting in earlier tends to improve returns. On the other hand, minimizing losses that result from bear markets does have psychological benefits, since most people feel the pain of losses more than the elation of gains. Kitces’ conclusion (and title of his Blog): “Dollar cost averaging may help to manage risk but on average it just reduces returns.”
So when a client calls in, based on the theory, I should be telling her: “Yes, it is a good time to invest and you should put everything to work now.” Right?
Not so fast. Most clients are actually asking me not only when and how to invest, but if it is okay to put their money at risk at a particular point in time. Although they know I can’t provide it, they want reassurance that the markets aren’t about to fall off a cliff.
The first thing a client and I talk about is why she wants to invest the money. Being tired of miserably low money market rates isn’t always enough. Her time horizon needs to be longer term; she needs to be prepared for market volatility; and the investment should be consistent with the financial plan we have created for her. Three years ago I wrote an entire blog on Investing Cash: The Timing Factor that is devoted to this topic.
Even after this lengthy discussion, if I still hear worry in my client’s voice, I may suggest that she dollar cost average into the markets, even though I know that statistically her returns may be less than if she invested the money upfront. Often times I will suggest that we divide the lump sum into two or three parts, not the strict monthly payments many DCA plans subscribe to. In doing so I risk that my client may balk at the second or third payment if market conditions deteriorate further. But that again is a teaching moment.
Let’s use an example where a client and I have agreed that she is ready to put some cash to work. It is January 2016 and the markets are falling hard with an overhang of excessive gloom. It is buy low time. But if the timing doesn’t sit right with the client, getting some cash to work, as the AllianceBerstein study showed, is better than continuing to hold cash.
Flash forward to February/March when the markets have recovered, dollar cost averaging may again be a reasonable approach. Adding some money after a rally and some money later could avoid frustration that can come from buying at a top.
That does not mean that I recommend dollar cost averaging to all of my clients. On the contrary, those who are comfortable with risk and are unlikely to experience regret when markets pull back, are encouraged to lump sum invest, as in theory they can benefit the most from this strategy. Younger investors, in particular, are good candidates for lump sum investing, as they are often more aggressively invested and have longer time frames.
In the end, there may be research that tells us which strategy is best for us. But the decision to put your money to work is ultimately your own. The goal is for you to take money that you have earmarked for certain goals, invest it and keep it invested until the money is needed. The timing issue is only one of many decisions you will make regarding this investment. So pick the strategy that you feel most comfortable with and then stick with the plan.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.