But sometimes, when feelings are involved, logic goes out the window.
A huge part of my job (to tell the truth, almost the whole job) is to take what the textbook tells us (the spreadsheet answer) and apply it in a way that allows people to sleep at night.
All the textbooks and tables on the planet can be there to show that the right thing to do is to invest a lump sum immediately without delay (the “lob it in” approach) - but when we are talking about life changing sums of money this can just be a really difficult thing to do sometimes.
And so, in descending order of appeal to me, here are the three options available to you if you don’t feel comfortable investing a lump sum into the market on “day one”.
Option Number 1 - Review your asset allocation.
When building an investment strategy, the number one question to answer is - “what should my asset allocation be”?
A primary objective of the financial planning process is to determine what level of return you need from your investments. Once we know this, we can work backwards to determine what asset allocation is required to make the plan sing.
But if, for example, we settle on an asset allocation where 80% of the portfolio is in stocks with 20% in bonds and cash - you as the investor need to be prepared mentally for a temporary fall in value of 24% every 10 years or so, and a temporary fall in value of 40% during a ‘once in a generation’ drawdown. Smaller temporary falls in value are to be expected more frequently.
This is the price that we all pay to secure our financial futures.
When you set out on your investing journey there is always the risk, however small, that you could be hit with one of these big falls straight out of the gate.
Be really honest with yourself - if this is likely to cause you sufficient mental anguish to throw in the towel, then we maybe need to recognise this and build in a little more defensibility in those early years to insure against a catastrophic outcome (a “panic sale” at the worst possible time).
One way to do this is to review the agreed asset allocation and reduce the exposure to stocks (being the highest return and highest volatility asset class of the three I have mentioned). Perhaps instead of having an 80% holding in stocks, we move this to a 60% weighting and increase the cash and bonds allocation from 20% to 40%.
The reason that I like this as the “next best option” to investing in line with your agreed asset allocation straight out of the gate, is that it requires you to make just three decisions.
First, decide what your temporary initial asset allocation is going to be. Second, hit the “buy” button. And third, decide when to review your asset allocation to bring it into line with the one required by your financial plan.
This approach requires less thought than option number two, and way less than option number three.
It also gets the capitalist compounding machine going as quickly as possible. But if history is any guide, by going down this road and choosing to invest initially in a more conservative asset allocation, you are likely to be giving up some return.
And if your financial plan shows that you need higher investment returns than your initial asset allocation would imply, you are just delaying the inevitable. You are going to have to bit the bullet and switch into the “correct” asset allocation at some stage.
Investment returns are the oxygen to your financial plan. The longer you stay trapped in an excessively defensive asset mix, the more you starve your plan of the energy it needs to succeed.
Option Number 2 - Drip it in (in a systematic way).
The second course of action that we can take to try and shield ourselves from excessive pain in the early innings of our investment journey, is to take our time investing the money. But in doing so, having some hard and fast rules about when and how the money will be invested.
Perhaps we divide our lump sum into 12 portions, and invest one each month. Or we divide it into 4 and do one each quarter. It doesn’t really matter.
The important point to make here is that we just need some rules that we agree to follow slavishly. Not doing so means that we end up with option 3 (which, as we shall see, is not where we want to be).
The advantage of taking this approach is that if there is a big market fall in the first twelve or twenty four months, when you still have a decent slug in cash, then the hit to your investments is relatively muted and you have the opportunity theoretically to buy in at lower levels.
The, fairly major, downside of this approach is that markets go up more often than they go down. By choosing this strategy you accept, historical probabilities being the best evidence that we have, that you are likely miss out on returns.
To illustrate this point, I have built a simple 80% stock and 20% bond portfolio in FE Analytics, and modelled what happened during the past 20 full calendar years to an investor with £1.2m if they followed two different investment approaches:
“Drip feeding” £100,000 at the start of each month into the portfolio; and
Investing the full £1.2m at the start of the year.
Source: FE Analytics, The Money Den. Returns are shown in Sterling terms for a portfolio comprised 80% MSCI All Country World Index and 20% Bloomberg Global Aggregate Bond Index (total returns, income reinvested). Returns are shown without any investment, advice or custody fees being deducted.
So, pretty conclusive. In just 4 of the past 20 calendar years were you better off “drip feeding” money into a diversified portfolio each month, rather than just “lobbing it in” on 1st January.
Like so much in finance, it is best to think of this concept in terms of insurance.
You are uncomfortable with the idea that you will experience a significant drawdown in the value of your portfolio during the first twelve months of investment, when you are arguably most vulnerable, so you decide to take your time investing the money.
Like with all insurance however, there is a cost. In this case however it is an implicit, but still potentially massive opportunity cost.
There is another big problem with taking this approach. Have a look again at the table, and the years when the “drip feeding” approach worked.
2022, 2011, 2009 and 2008 were brutal years for the stock market. As such, having some money to take advantage and buy-in when the market fell by a lot proved extremely handy.
But following this strategy assumes that you will be prepared to rigidly stick to it during periods of peak turmoil. While it isn’t great fun being fully invested when the market is falling by a lot, there is somewhat of a sense that it is a fait accompli.
You can’t really do anything about it - get your head down, sit on your hands, live through it.
If, on the other hand, you have cash to deploy into a falling market you have to actively choose to buy into the teeth of whatever crisis is befalling the world at that particular time.
“Cost of living crisis” - BUY
“Eurozone debt crisis” - BUY
“Global Financial Crisis and the end of capitalism as we know it” - BUY
It is a cruel irony of the “drip feeding” strategy that it only works after demanding so much of you as an investor.
Again, we must ask ourselves honestly if we are going down this road - are we prepared to actively keep investing, even if it feels like the world is falling apart around us?
Option Number 3 - Drip it in (by feel).
The final option is not even an option. It is the worst of all worlds.
The only value that this strategy offers is as a filter for your due diligence.
If someone sits in front of you, with a straight face, and tells you that they can invest money into the market on your behalf at a “good time” - you can walk out of that room confident that you are dealing with either a charlatan or a moron.
Investment into capital markets cannot be timed. I know that this is now cliched advice, like remembering to get enough sleep and eat your greens, but it is an irrefutable truth. The earth is round.
The reason that capital markets cannot be timed is because they behave incredibly counter-intuitively all. of. the. time.
You might through wisdom, foresight or more likely luck predict a certain event - but you have absolutely no idea how an infinitely complex system like the global equity market will react to that event.
On the 22nd November 1963 John F Kennedy, the President of the United States, was shot dead. Truly seismic news, with potentially huge unknown ramifications for the world. The US stock market was immediately closed on the news.
The next morning it opened up by more than 4%.
This is just one example, there are countless others.
Capital markets have no feelings, they have no need to behave like we might expect them to and they damn sure don’t care about making us all look stupid from time to time.
If we want to insure ourselves (for free!) against looking stupid, then we need to make fewer decisions. Get invested, stay invested and remember that the most confident predictions usually come from the least enlightened.
Past performance is not indicative of future returns. Nothing that I say in these pages is intended to constitute advice to anyone. If you want advice on your individual situation, please consult a regulated financial planner.
Comments