This is one of those questions that does not have a straight answer, and depending on who you ask, you might get a different opinion. But most experts do tend to favor lump sum investing. After all, the sooner you invest your money, the greater your chances of a getting a good return.
I do trust expert opinions, but I’d like to verify them as well.
Two Roads Diverged In A Yellow Wood…
Lump Sum Joe and Risk Averse John, both came across a windfall – $13,568.42 to be exact. Both being sensible investors, decided to invest the money in a low cost index fund. Both chose VFINX that tracked the S&P 500.
But that’s where their investing approaches end.
Lump Sum Joe decided to go with the popular opinion and took an invest-and-forget approach by investing all of $13K at once.
…And Risk Averse John Took The One Less Travelled By
Risk Averse John, being well, risk-averse, decided to go against conventional wisdom and stagger his investments by buying one share of VFINX every month till the money ran out. Not exactly dollar cost averaging, but a similar approach to mitigate risk.
And That Had Made All The Difference.
Both started investing on Jan 1, 1999 and Risk Averse John’s money ran out on Dec 1, 2008. A span of exactly one decade.
- Lump Sum Joe received 114.27 shares of VFINX for his $13K in 1999 at $118.74/share
- Risk Averse John had 120 shares of VFINX at the end of 10 years when his 13K ran out
Contrary to what one would expect, Risk Averse John came out ahead of Lump Sum Joe, despite taking on lower risk.
So what happened? Were the experts wrong?
To understand this, we have to take a closer look at conventional wisdom. Why is lump sum investing normally considered better? Because of three factors. Time, which can smooth out market fluctuations, power of compounding, especially true if you use strategies like dividend reinvesting and finally, optimism. You invest hoping tomorrow will be better than today.
Joe and John started investing when times were good, really good. The country had a surplus, 9/11 hadn’t happened yet, the economy was thriving and people were looking forward to the new millenium with hope and optimism. Alan Greenspan, the then Fed chief called the mood irrational exuberance. It truly was if you were invested during that period. Traditional companies were changing their names to end in .com and such moves paid off by boosting stock prices! And hence the name ‘dotcom’ era.
But in a span of 10 years, things went very sour. Bush was elected. 9/11, two wars, unprecedented spending, dot com crash, real estate crash and finally it all culminated to one of the worst recessions in 2008. And that’s about the time Risk Averse John’s 13K ran out, when the market was at one of its lowest point.
In 10 years, the markets instead of gaining, had in fact gone down. The third ingredient – optimism was missing and Lump Sum Joe’s gamble didn’t pay off. Risk Averse John won.
No expert can predict future performance. For an individual investor, here’s what I recommend:
- Discipline. Have a plan, stick with it, no matter what
- Diversification. Investors who were all stocks during the lost decade saw their investments crushed as opposed to those who had a mix of Stocks and Bonds
- Asset Allocation: Spend your energy not in picking individual stocks, but in picking the right asset classes
With many apologies to Robert Frost for my twisted interpretation of his poem The Road Not Taken!