The Compound and Friends - This investment strategy beats dollar cost averaging (with Josh and Nick)

Episode Date: September 25, 2019

Josh Brown and Nick Maggiulli, of Ritholtz Wealth Management, discuss data on investing a lump sum vs dollar-cost averaging, and the results might surprise you. Read Nick's post for the data and charts: https://ofdollarsanddata.com/the-cost-of-waiting/ 1-click play or subscribe on your favorite podcast app   Subscribe to the mini podcast on iTunes or Spotify    Enable our Alexa skill here - "Alexa, play the Compound show!"   Talk to us about your portfolio or financial plan here:  http://ritholtzwealth.com/   Obviously nothing on this channel should be considered as personalized financial advice just for you or a solicitation to buy or sell any securities. Please see this 3,000 word terms & conditions disclaimer: https://thereformedbroker.com/terms-and-conditions/   #Stocks #StockMarket #MakeMoney #Wealth #HowToInvest #Investing #Money #Trading #RetirementInvesting #FinancialAdvice #InvestmentAdvisor #FinancialAdvice #PersonalFinance Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

Hey, I'm downtown Josh Brown. I am here with Ritholtz-Welts Chief Data Analytics Manager, Nick Maggiuli. You may know him from his incredible blog of dollars and data. And Nick wrote about the difference between lump sum investing, dollar cost averaging, and then asset allocation. Those being your three choices to invest basically excess cash and inheritance. And you were not terribly surprised by what you found, but I think a lot of other people would be surprised. Tell us what you learned. So earlier this year, I wrote a post

which was comparing, as you said, a lump sum investment to someone who averages in over time. So slowly buying the S&P 500. Yeah, let's say you had a lump sum. Let's say you had like, you know, you got some sort of windfall. Maybe you sold a business. You have a couple million dollars. Like a monopoly.

I won a beauty pageant. Yes. $200. Except it's like $2 million. And also that would never happen. Yes. So instead of putting it all in at once into stocks, you would average in over time. And so doing that, I found that it's almost always optimal to go in all in at once, right?

No matter what the time period is, the longer it is. Okay, so putting the whole lump sum into stocks historically has been better than lump sum investing over time because of the market's tendency to go higher over time. So the sooner you get invested. Yeah. So most people, when they hold up, they're like, oh, I'm kind of afraid. It's because they think there's going to be a dip. And sometimes there is, and that's unfortunate. But most of the time, the market keeps going up. And so if you'd been waiting for a dip, let's say even in 2012, you've been waiting for a dip, you'd still be waiting for a big dip. Okay. So that's not controversial. And when you did that, it got a lot of attention just because

I think you illustrated it in a way that many people haven't seen before. Yeah. And we discussed that before on the channel. Right. Okay. So now you've taken it a step further and you've said, okay, invest the whole lump sum is best. Dollar cost averaging is okay. But here is actually the best of both worlds almost. What if you just add to an asset allocation portfolio that has stocks and bonds? Does that beat dollar cost averaging? And what did you find? Yeah, I found that you can, so instead of just going all into stocks, what if you went all in on a more conservative portfolio?

Some stocks, some bonds instead of just the all in to stocks, what if you went all in on a more conservative portfolio? So some stocks, some bonds, instead of just the S&P. Yeah, and so the whole idea with that is like, OK, obviously someone's afraid to go all in on stocks. The market might dip. So I'm like, what if you just went in all in on like a 60-40 portfolio, or 50-50, or even go all the way down to 100% bonds? What would happen comparing to averaging into stocks over time?

And I found in the most extreme case that basically throughout history, since 1960, over any 24 month period, if you had just went 100% into bonds, that would have performed about the same as going into stocks over the next two years, which is kind of insane when you think about it. Like 100% bond portfolio now is going to perform the same as a 100% stock allocation over two years of averaging in every okay so you basically took the S&P 500 as the stock proxy and then for fixed income what did you use the ad a five-year five-year five-year treasury yeah so not even taking any risk with

agency bonds nothing corporate okay so what you're basically saying is that the more you're weighted towards stocks the the better. But even if you had no weighting to stocks and you just did an all bond portfolio, you still, on average, did better doing that than doing the dollar cost average. Yeah. On average, slightly better. Yeah. They're basically break even at that point. But that's just insane.

The volatility is way less. Yeah. Yeah. No one's going to go 100%. I mean, bonds, when you want your true allocation, would be 100% stock. It's just mind. But the volatility is way less. Yeah, yeah. No one's going to go 100%. I mean, bonds, when you want, when your true allocation would be 100% stock. It's just mind-boggling. It's just saying, like, the whole point is, like, you should be in, like, something more conservative.

So put it all in now. Just put in a more conservative portfolio. Do a 60-40. Do a 50-50. It doesn't really matter. So the big takeaway from your piece, and I want to get into why that's relevant for investors and then also for financial advisors who advise investors.

But your big takeaway is, yes, it's scary to take a pile of cash and throw it at the stock market. And a lot of people would say, OK, so why don't you just take 10% and add it to the market every month and then eventually you'll be fully invested, but you will not have picked one price. And there's nothing wrong with that by the way that's perfectly fine you won't do as well on average but here's a happy medium rather than choosing between those two pick an asset allocation to your point let's say it's 60 stocks 40 fixed income and what does that look like over two year rolling two year periods on average versus just a simple dollar cost average if you were to do

that I mean I don't have the number being to send the post but it's like you're gonna outperform most of the time and probably like I'm guessing like close to 70% of the time you'd all perform so in all rolling two-year periods and there are probably hundreds of them and yeah yeah since 1960 yeah you're just rolling and like most of the time, you're going to outperform. You're going to outperform by a small amount, a couple percent. Enough that it was worth it. Yeah, yeah, of course, yeah.

And so the whole idea is just get in the market now. So why does DC underperform? Why is it putting in overtime to perform? Because the cash is sitting there, and it's not invested. It's earning nothing. Yeah, and so some people say, well, what if you put the cash in a money market fund or something? I did that. I ran that analysis.

And it does change it a little bit, but it doesn't change it enough. Like the main point still stands. It's going to move it a little. So for example, the 100% bond is no longer outperforming the DC and all stocks. I was going to say, what's the money market? Yeah, it's going to move. It's going to move over. Yeah.

So if the money market earns more, it's going to move it over. But still, like a 40-60 portfolio, which is only 40% in stocks, even when your cash is earning, the DCA cash is earning over something like, I use treasury bills in this case, but even if it's earning money, you're still going to underperform. You're still winning because you don't have that drag of money earning very little or nothing these days. Cash earned, I mean, think about this. If we get 2% a year, you run that for a year, that's the annual inflation rate, right? Let's just assume it's 2%.

Some will say it's higher, but at 2% a year, every day you lose 50 basis points. If you have 10 grand in cash right now, every single day, you're losing 50 cents. I mean, it's not going to seem like much, but on a million bucks, that's $50 a year or something like that. So I like that you went back to 1960. Because if I were somebody who wanted to criticize your premise, I would have said, well, interest rates have been falling since 1981. So you're studying like a mono environment. So you actually have data showing an entire period in which interest rates rose and rose substantially, frankly. And then also this period where interest rates fell. So you've got both sides of the pendulum.

Yeah. And if you look at some of the charts when you see where the underperformance, outperformance occurs, there's no sort of regime effect. There's no rhyme or reason. Oh, yeah. Yeah, there's no. If you look at it, it looks like it's jumping all over the place. It's not like, okay, in the early 80s it did worse or did better. It's like it's jumping all over the place.

And because of that, I think it makes the results even more trustworthy in this case. Right. of that, I think it makes the results even more trustworthy in this case. Right. So the ramifications for financial advisors, one of the biggest challenges that we have, we speak with a prospective investor. And in a lot of cases, they're coming to us with, yes, a portfolio, but then also a lot of excess cash. And that's part of the reason they're coming to us, because the bond market has done well, the stock market has done well, but they've had too much in cash. They've not been able to bring themselves to invest. And a lot of that is because they don't have confidence in what they're doing, how they're

investing. And then, of course, they have the same concern that we all have. What's going to happen in the future? Am I going to get fully invested right before the market top? And that behavior manifests itself in five-year periods where people sit in cash with two-thirds of their money, a third of their money. Okay, so we run into this all the time.

And it's almost as though people want someone to tell them, yes, invest it, but then they still don't want to do it. The work that you've done and the charts that you've put together, which we'll link to in the show notes, I just feel like that's a really great way to explain to people why we don't sit around waiting for this magical moment to happen that A, you can't predict, and B, when it does happen, that's the time you'll be least confident to invest. So it's not even like it'll help you. And I'm sure you hear stories like this

all the time. Yeah. And I think the main thing is like, you just need to, as long as you have enough cash for your, like your outlays, like your emergency fund, basically, however long you have a year or two or whatever, whatever. Separate money. That's a separate question though. And this is like, after you have those taken care of, then this money is like, you need to put that in the market. And I'm not saying it needs to be in the stock market. It could be in the bond market. It just needs to be in some diversified portfolio. Maybe it's even more conservative than what your original investment thesis was. Or when you first sat down with the planner, you said, OK, it looks like I need 80-20.

But then you get this $10 million windfall or some big whatever it is, some large amount of money. And now you need to invest that as well. Maybe you put that in a more conservative thing just because you're worried. And that's fine. And then you can, at some point in the future, you can start transitioning back to your proper allocation. There's different ways of doing it.

There's no perfect answer to this. But I feel like that's the right way to go about doing this. Because sitting in cash, you're just going to your proper allocation. There's different ways of doing it. There's no perfect answer to this, but I feel like that's the right way to go about doing this because sitting in cash, you're just going to get eaten alive. I mean, inflation is going to keep, I mean, I don't say it's going to go up, but I'm saying inflation will be around. I doubt that we're going to have deflation going forward. I just think inflation is something that's here to stay and it's going to stay constant for some of us.

So now one last interesting thing in that vein. So I'm 42. My generation is now watching their parents pass away and they're inheriting money. It's not always a lot of money, but still anything that you inherit, it's got this burden attached to it that's bigger than just the money. It's almost like this is the legacy, the financial legacy of a parent. And it almost doubles the amount of responsibility that you feel to invest it. And with that added responsibility comes a lot of emotional baggage. I don't want to make a mistake. My father worked his whole life.

My mother worked her whole life to build this up. And it's almost, I don't want to say paralyzing, but like it absolutely puts people on edge, even people that have been confident in investing their whole lives. They almost see this as something different. So that's why I think what you've illustrated is so powerful and I think what it's saying is yeah, there is a likelihood that you take this money and fully invest it in stocks and bonds and it's not a great time to have done so. But number one, the odds are not on the side of that argument. The odds are on the other side. And number two, what if you do nothing? That's

not actually an answer. So somewhere in between invest it all in stocks or do absolutely nothing, sit in cash. I like this as an alternative asset allocation pick how much risk you want within that asset allocation and just understand that the math is on your side yeah yeah I would say just be more especially you said there's this emotional baggage there just be more conservative in the portfolio if you're really worried about losing that money then you know put it into a portfolio with more bonds of more safety where it's less likely that something

like this would happen. So I mean, there's no guarantees with any asset, but stocks versus bonds, just load up on more bonds, and that should take care of that. Now, obviously, you're still taking risk on the far end. If there's not enough return on that money, that money will dwindle away the higher your bond percentage is, historically, at least.

So it's whether it's, I mean, you're taking the risk somewhere, right? If you just sit in cash, like, yeah, you're never going to lose a dollar. But then 30 years from now, that's going to, the purchasing power is going to be cut in half, I mean, you're taking the risk somewhere, right? If you just sit in cash, like, yeah, you're never going to lose a dollar. But then, you know, 30 years from now, that's going to, the purchasing power is going to be cut in half, maybe more, right? So it's your call of what you want to do. Risk is why you're earning anything on it. Yeah, of course.

Yeah, you got to take a little bit, right? All right, so listen, at the end of the day, the most important thing is that you are assuming some risk because there's no such thing as no risk. We just have different types of risks. This is Nick Maggiuli. I'm Josh Brown. Make sure you're following and subscribe to the channel and make sure you're subscribed to Of Dollars and Data. That's Nick's blog. He posts regularly every Tuesday. Every Tuesday. Don't miss it. Go ahead and smash that like button for us and we will be back soon.