Jump or Ease In? Lump Sum Versus Dollar Cost Averaging

The Water is Fine

The Autumnal Equinox, aka the first day of Fall, was last week on September 22. You may not have noticed, as the high for the day was 94° F here in ATX. Yesterday, though, we woke to the first day in over six months that the thermometer read below 60°. This became VERY apparent when I stuck my toes in the water prior to my morning swim at our neighborhood pool.

Even though most will agree that jumping in and getting the initial shock over with is typically the best way to acclimate to cool water, it can be difficult to convince our minds that a more cautious approach isn’t more prudent after getting cold feet.

Frequently this dilemma also presents itself with investing. The question of whether to “jump in” the market and invest immediately versus employing a more gradual approach such as dollar cost averaging regularly comes up in my conversations with clients that have cash to invest. So what is the best approach?

12 time Olympic medalist, Natalie Coughlin, was once quoted as saying, "I actually love swimming but I just hate jumping in the water." If even the most successful pros face the same mental challenges as the rest of us, maybe the question isn't which approach is best. Rather, what does it take to get you in the pool?

First, let’s not confuse the question of what to do with a lump-sum versus accumulating wealth over time. If you don’t have a lot of money to invest and want to start by taking small amounts from your income (such as in an employer retirement plan like a 401(k)) and investing over time, by all means, do that. It is an effective way to grow your nest egg.

But if you have already saved up a pile of cash or had a liquidity event and want to invest for the long haul, decades of research[i] suggest that investing it all at once, or lump-sum investing, tilts the odds in your favor around 66% of the time. Nonetheless, that 66% is a lot like 66° water for a lot of folks. Some have the fortitude to jump right in, others need to convince themselves through a more cautious approach.

Stocks and bonds have expected returns that are higher than cash, so it stands to reason that the odds favor them to outperform over time. Another way to think about it is that for 2 out 3 investors, increasing stock and bond prices will just lead to higher average prices paid through dollar cost averaging (See exhibit 1). However, volatility is the trade-off for those higher expected returns.

Exhibit 1: For 2 out 3 investors, dollar cost averaging will increase the average price paid as stock and bond prices tend to go up over time.

If the prospect of being on the short end of the stick about a third of the time is just too uncomfortable of a thought for you to jump right in, then dollar cost averaging may be the way to go. Besides, just as you can always dunk your head in the water to get it over with, you can accelerate your investment schedule if you acclimate sooner than you expected.

Either approach is better than staying in bed while your muscles wither from inactivity or purchasing power is diminished by inflation.  Time for a swim?

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[i] Abeysekera, Sarath P., and E.S. Rosenbloom. 2000. “A Simulation Model for Deciding between Lump-Sum and Dollar-Cost Averaging.” Journal of Financial Planning 13 (6): 86–96.

Atra, Robert J., and Thomas L. Mann. 2001. “Dollar-Cost Averaging and Seasonality: Some International Evidence.” Journal of Financial Planning 14 (7): 98–103.

Brennan, Michael J., Feifei Li, and Walter N. Torous. 2005. “Dollar-Cost Averaging.” Review of Finance 9 (4): 509–535.

Constantinides, George M. 1979. “A Note on the Suboptimality of Dollar-Cost Averaging as an Investment Policy.” Journal of Financial and Quantitative Analysis 14 (2): 443–450.

Dichtl, Hubert, and Wolfgang Drobetz. 2011. “Dollar-Cost Averaging and Prospect Theory Investors: An Explanation for a Popular Investment Strategy.” Journal of Behavioral Finance12 (3): 41–52.

Dubil, Robert. 2005. “Lifetime Dollar-Cost Averaging: Forget Cost Savings, Think Risk Reduction.” Journal of Financial Planning 18 (10): 86–90.

Greenhut, John G. 2006. “Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work.” Journal of Financial Planning 19 (10): 76–83.

Knight, John R., and Lewis Mandell. 1993. “Nobody Gains from Dollar-Cost Averaging: Analytical, Numerical, and Empirical Results.” Financial Services Review 2 (1): 51–61.

Leggio, Karyl B., and Donald Lien. 2001. “Does Loss Aversion Explain Dollar-Cost Averaging?” Financial Services Review 10 (1–4): 117–127.

Leggio, Karyl B., and Donald Lien. 2003. “Comparing Alternative Investment Strategies Using Risk-Adjusted Performance Measures.” Journal of Financial Planning 16 (1): 82–86.

Markowitz, Harry. 1952. “Portfolio Selection.” Journal of Finance 7 (1): 77–91.

Milevsky, Moshe A., and Steven E. Posner. 2003. “A Continuous-Time Re-examination of the Inefficiency of Dollar-Cost Averaging.” International Journal of Theoretical and Applied Finance 6 (2): 173–194.

Rozeff, Michael S. 1994. “Lump-Sum Investing versus Dollar-Averaging.” Journal of Portfolio Management 20 (2): 45–50.

Statman, Meir. 1995. “A Behavioral Framework for Dollar-Cost Averaging.” Journal of Portfolio Management 22 (1): 70–78.

Thorley, Steven. 1994. “The Fallacy of Dollar-Cost Averaging.” Financial Practice and Education 4 (2): 138–143.

Trainor, William J. 2005. “Within-Horizon Exposure to Loss for Dollar-Cost Averaging and Lump-Sum Investing.” Financial Services Review 14 (4): 319–330.

Williams, Richard E., and Peter W. Bacon. 1993. “Lump-Sum Beats Dollar-Cost Averaging.”Journal of Financial Planning 6 (2): 64–67.

3 Lessons from Being Self-Employed

44% of new businesses fail in their first three years, according to Statistic Brain.

In spite of knowing the odds, about two years ago I left the steady paycheck, benefits, and general comfort of a corporate job for the world of self-employment. I’ve replaced the predictable paycheck with the potential for big ones, the benefits with freedom and flexibility, and general comfort for sleepless nights worrying if I can provide for my family.

It is very exciting being fully in-charge of my own success, but the thrill is frequently tempered. First there is daily reinforcement that I often don’t know how to do something or even that I don't know there is something that I don't know. Then, once I figure it out, it will probably cost more money than I have budgeted for it. Then, finally, no matter how long I think that something will take, it always takes at least twice as much time.

Today’s update may not eliminate the ever present challenges mentioned above. But there have been some lessons I have learned along the way that may help those of you that are considering making your dreams of self-employment come true. At the very least, perhaps they will help prevent you from waking up to a financial nightmare.

Build a Big Emergency Fund

I had about 12 months of normal expenses in cash the day I left my job. I wish now that I had twice that amount. Things that once weren’t emergencies, such as new HVAC for my home, car repairs, and just the everyday costs of raising two teenagers quickly whittled down my rainy day fund. 

Nearly every successful entrepreneur I have met can tell a story about how short the runway is between starting the business, when they are spending their capital, and getting it off the ground when the enterprise actually turns a profit. No matter how flush you may feel at the beginning, the trees at the end of the runway will rapidly approach as you accelerate while struggling to gain lift.

Whatever you think you need in your emergency fund, double or triple it before taking off.

Take the credit before you need it

No matter how long you’ve been employed, how much money you used to make, or have saved up in your 401(k), the moment you walk away from the steady paycheck is the day the credit river will slow or even run dry. The time to refinance your mortgage, obtain a line of credit, or get your credit limit increased on a credit card or two is before you walk out the door to be the next Bill Gates.

Once you’re your own boss, creditors will want to see sustained success (typically two years) before considering you even a moderate risk. Even if you can find a willing lender, the rates will likely be higher than when you fit in a nice clean credit profile of a gainfully employed borrower.

Throw in the fact that underwriting standards are still pretty stringent following the mortgage meltdown in 2008, and you can almost forget about getting new credit unless you have assets to borrow against.

Don’t be shy about taking as much credit as possible before making the leap to self-employment. You’ll appreciate the flexibility of being able to pay off big expenses with the lowest monthly obligation as possible.

Record it!

“It’s ok, I can deduct it,” may be true, but make sure you can prove it. Being a business owner allows you to offset revenue with expenses for things like office supplies, equipment, mileage, etc. Being sloppy with record keeping, however, can be costly in the event of an audit. According to the IRS 2015 Data Book, returns filed with a Schedule C (Profit or Loss from Business) with income greater than $25,000 are 8 times more likely to be audited than someone with similar income that isn’t filing small business schedules or claiming certain tax credits.

While the chances of being audited are still relatively low (between 2%-3%), you can avoid the headache of having expenses disallowed or additional taxes owed (and penalties) by saving receipts, keeping your calendar records, and tracking your mileage with a phone application like MileIQ.

Create a system, whether it is technology based or just a folder, to keep and track all of those expenses. Your accountant will thank you.

TIP – Cats like to eat receipts left on your desk.

Be Accountable to Yourself

New business owners tend to focus on what they do for a living, and rightly so. There is no doubt that offering a great product or service is a key to success. Many businesses fail, however, in spite of offering a compelling value proposition. The failure isn’t always due to failing to meet the needs of their customers, it often comes from not being accountable to themselves as they focus on what they do best and neglecting the actual business.

Taking these lessons to heart may not guarantee your success as an entrepreneur, but they will go a long way towards helping you avoid becoming a bad statistic. 

Finance Question From the Campfire: Do Lifetime Hunting & Fishing Licenses Make Sense?

My little huntin' buddy.

As a kid growing up in Texas, I dreaded the evening sportscast in mid-July on the local news that announced that the Dallas Cowboys had started their training camp. Don’t get me wrong, I grew up idolizing players such as Roger Staubach, Tony Dorsett, Drew Pearson, Ed “Too Tall” Jones, Randy White, etc. One of the highlights of my youth were those Sundays that the Cowboys played at noon and the preacher would dismiss church 10 minutes early so no one would miss kickoff.

So, why the disdain for training camp? It was simple, it meant summer was almost over!

As I got older though, my contempt for Fall turned to affection. Baseball playoffs, football at all levels, and for most in the rural Piney Woods of East Texas, the three D’s of Dove, Duck, and Deer season were upon us.

I’ve even managed to marry some of these passions as the wonder of satellite technology now allows us to watch our favorite teams on TV while sitting around a fire at deer camp. Rarely, however, do I find the opportunity to apply my experience and knowledge from my day job to the campfire conversations. That was until a recent trip to the field when the mundane topic of hunting licenses came up.

For those of you that limit your hunting to aisle numbers at HEB, you should know that Texas requires you to purchase a license in order to hunt or fish. There are variety of choices when it comes to purchasing these government permission slips. As a citizen of the Great State, you can buy a Resident Hunting License and/or a Resident Fishing License. You can add stamps for archery, freshwater fishing, saltwater fishing with a red drum tag, upland game bird, and migratory game bird. If you want to have them all, you can purchase a “Super Combo”, which currently costs $68 annually. (Active duty military and disabled veterans are free, and for age 65+ it drops to $32.)

The conversation centered on the value of the Lifetime Resident Combination, which currently will set you back $1,800.  Some of us there had purchased the Lifetime License when they were less expensive, as little as $600. Most of those folks felt that the purchase was a great deal as they had long ago “broke even” on their investment. For those that were still considering making the annual purchase, opinions varied wildly.

Since I generally don’t include things like an HP 10bII Financial Calculator in my gear pack when headed to the field, all I could do is more or less agree that the simple arithmetic of the 26+ years it would take to “break even” ($1800/$68) wasn’t a great bargain. But I left wondering how good or bad of a deal it really was. When I got back in the office on Monday, I started crunching some numbers.

If you think of the Lifetime License as an income annuity, one that provides at tax-free inflation adjusted payments for life, you can then calculate the returns based on the number of years payments are made and compare to returns of other vehicles to understand how competitive of an “investment” one of these licenses may actually be.

My first calculation added in a modest inflation rate. Assuming license prices increase at 2% per year, at the current $1,800 Lifetime License fee, it will actually only take about 22 years to recoup your investment. The internal rate of return (IRR) in year 22 is a whopping .25% per year. That’s not exactly a score you’ll be bragging about at Christmas parties in a few months.

By year 32, the IRR has risen to 3.08%. That compares favorably to what you would earn by purchasing a 30-year AAA rated Texas municipal bond today. By year 40, the IRR rises to 4.12%.

Exhibit 1. Annual Texas Super Combo License cost at a 2% inflation rate versus the internal rate of return (IRR) of a Lifetime License.

What if you put the $1,800 in a diversified stock index fund and drew out what you need each year for the license? You definitely would come out ahead, right? Well….

I ran a simulation with the same assumptions as above using a method known as Monte Carlo analysis. My financial planning software, Money Guide Pro®, makes this much easier than using my calculator. Think of the Monte Carlo as using a deck of cards, each with a particular year’s historical return of the stock market written on its face (in this case, I used a global equity portfolio similar in construction to our “All Equity” Accountable Portfolio that is allocated 60% US Equity, 20% International Equity, 10% Emerging Market Equity, and 10% Global REITs).

We shuffle and deal out the 42 cards and then tally the results using those returns in the order they are dealt. A successful outcome leaves you with at least $1 at the end of the 42nd calculation while a failure ran out of money somewhere along the way. This is considered a better way to model portfolio withdrawal scenarios versus using average returns because averages don't show the risks of how sequences of various returns that equal the same average can result in much different outcomes.

If you shuffle and deal 1000 times you can eventually get a decent idea of the likelihood of success of a particular strategy. In this case, the percentage of outcomes that resulted in having money left over was 63%. That’s better than a coin flip but far from the "no-brainer" I thought it may be when I started this article. Considering I bought my Lifetime License when they were only $1000, I’m feeling pretty good about my decision.

I feel even better about buying one for my son, who was only 8 years old at the time. There is one other benefit that can be especially attractive when buying the Lifetime License for a youngster, and that is if they ever move out of state they won’t have to buy a Non-resident Hunting License (currently $315 + applicable stamps a year) when they come home to visit.

So even if faced with making the purchase today, I would still buy one for him at the current amount because the math ain’t bad. At age 48, however, my decision would be based more on optimism or a burning desire to live long enough to stick it to the government.

Of course, anything that makes it easier to spend quality time with my “little” hunting buddy in the great outdoors is priceless. Happy hunting!