Dow 15,000! S&P 1600! The best start to a year for stocks since 1999! As the stock market continues its ascent, the most frequently asked question that I am receiving is: “Should I buy or is a correction coming?”
Recently on CNBC, Warren Buffett predicted that stocks will go "far higher" in the long run, so for those with 10 or 20 years to go before they need their money, there is no reason to alter your game plan – keep investing in a diversified portfolio. That said, stock indexes have gone 6 months without even a 5 percent correction – the last "classic" correction (defined as a 10 percent drop from the highs) occurred in the summer of 2011, when the S&P 500 plummeted by more than 17 percent after the debt-ceiling debacle.
So is a correction coming? Of course it is, but predicting when that will happen and trying to capitalize on it is a fool’s game. 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 and bond positions?
Part of the problem is that many investors are still stinging after the 54 percent drop from October 2007 to March 2009. As if that were not enough, confidence was shaken periodically during the recovery, whether from the 2010 "Flash Crash", the 2011 swoon or drops attributed to the European debt crisis. Those events may explain a recent Bankrate.com Financial Security Index, where a whopping 76 percent of respondents were just saying "no" to stocks. Economists call this “recency bias,” which means that we use our recent experience as a guide for what will happen in the future. So when stocks are soaring, we think markets will keep rising, but when the market plunges, we become convinced that it will never rise again.
But nearly 4 years since the end of the Great Recession, many investors are starting to ask whether it is safe to buy stocks. The answer is NO -- stocks are not a safe investment. 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.