The Dow and S&P 500 stock indexes are making new highs and it's been more than five years since the markets bottomed out, but that's not enough to convince many investors to jump back in. According to new research by State Street, retail investors across the globe were holding an average of 40 percent of their assets in cash, up from 31 percent two years ago. The lowest levels of cash holdings were in India, at 26 percent; the highest was 57 percent in Japan. The US was in the middle at 36 percent, but that was an increase of 10 percentage points in just two years. This jump was equal across the age spectrum: Retirees or near retirees hold 43 percent; Baby Boomers have 41 percent; Gene X are at 38 percent and the Millenials are at 40 percent. After a once in a generation financial crisis and a severe recession, these investors, regardless of age, aren’t able to stomach the market's roller coaster ride.
So should the risk averse buy back into stocks? Murphy's Law would say that the day after they do finally pull the trigger, the long-awaited for correction will come storming into town. (The S&P 500 has gone nearly two years without a 10 percent correction – the last one occurred in the summer of 2011, when the S&P 500 plummeted by more than 17 percent after the debt-ceiling debacle).
That leaves many would-be stock investors with a tough choice: should they get back into stocks after markets have more than doubled or should they remain in their cash positions? If you are the kind of person who simply cannot handle the ups and downs of the stock market, then your inclination is probably to avoid stocks at all costs. But what if you kept your stock allocation to a level where they gyrations didn’t cause you to lose sleep? Maybe a stock allocation of 10 to 20 percent of your portfolio would allow you partially participate over time, but not get your hat handed to you if/when the bottom falls out.
However, if you realize that you are ready to build a long-term investment portfolio using stocks as part of your allocation, the big question is whether to invest your cash all at once (lump sum investing or LSI) or whether to use dollar cost averaging (DCA). Dollar cost averaging is the investment strategy that divides the available money into equal parts and then periodically, putting the money to work in a diversified portfolio over time. According to research from Vanguard, two-thirds of the time, investing a lump sum yields better returns than putting smaller, fixed dollars to work at regular intervals.
The mutual fund giant analyzed returns from 1926 to 2011 and found that a lump sum portfolio comprised of 60 percent stocks and 40 percent bonds over rolling 10-year investment periods beat dollar cost averaging by 2.3 percent. In other words, if you had invested $1 million all at once, it would have led to an average ending portfolio value of $2,450,264 after 10-years, versus DCA for the same portfolio, which would have been worth $2,395,824.
The $54,440 differential may be large enough for you to go for the lump sum without looking back. But what if the lump sum decision were to occur at the beginning of a terrible 10-year period for stocks? While lump sum may beat DCA two-thirds of the time, DCA still returns more one-third of the time.
If you are the kind of investor who is less concerned with the probability of earning and more worried about losing a big chunk of money immediately, you may want to stick to DCA. Vanguard’s study notes “risk-averse investors may be less concerned about averages than they are about worst-case scenarios, as well as the potential feelings of regret that would occur if a lump-sum investment were made immediately prior to a market decline.”
It is often said that there are only two emotions in investing: fear and greed. If you are tempted to add regret to that list, tread carefully as you make this decision.