What to Do If You're Light on Stocks

Morningstar's recent Portfolio Makeover series featured a broad range of situations. The investors we profiled ranged from 35-year-old whippersnappers to an 83-years-young retiree, and their goals, portfolio values, and investment choices varied significantly, too.

These investors all had one key thing in common, though: All were light on stocks given their time horizons and anticipated spending needs from their portfolios.

But saying a portfolio is equity-light is one thing. Actually ramping up into a higher equity weighting is another.

Looking only at the numbers would suggest that investors should get their money invested in stocks as soon as possible. After all, stocks generally trend up, and beat cash and bonds, over time. So the longer your money is invested in stocks, the better your outcome is likely to be. That was the finding of a Vanguard study published two years ago.

Yet generating the highest possible return isn't all that matters in the real world of investing, as students of behavioral finance know. Investors are also concerned about losing money--even more than they are about making it. By topping up an equity stake in a single shot, investors run the risk of deploying all that cash prior to a market correction or even a bear market. Encountering big losses shortly after investing could heighten the temptation to get out of the market altogether, when it's at its nadir--a recipe for disastrous investment results. That risk isn't just theoretical, either, as Morningstar's investor return data demonstrate.

"If humans were unemotional computers," says Rick Ferri, founder of Portfolio Solutions, a registered investment advisory firm in Troy, Mich., "they would always go straight to the higher equity allocation because that has the highest probability for long-term success. However, we're emotional beings, and that's why we have dollar-cost averaging."

DCA to the Rescue?
Dollar-cost averaging simply means that you invest a set dollar amount each month until your asset allocation is in line with your target. Dollar-cost averaging, by definition, means that you'll never deploy all your assets at precisely the right time. But by spacing out your purchases, you're buying stocks at a variety of purchase prices--some perhaps higher, some lower.

Say, for example, your $500,000 portfolio holds $250,000 in stocks and stock funds and the rest in bonds and cash, but you're targeting an 80% equity weighting ($400,000) instead. By pulling $12,500 per month from your cash and bond holdings and deploying the money into stocks, your equity weighting would be in line with your target within the space of a year ($12,500 X 12 = your desired increase in equities of $150,000). If stocks go higher during the dollar-cost averaging process, you could hit your target allocation even more quickly.

That sounds straightforward enough. But once you scratch the surface, dollar-cost averaging raises as many questions as it answers. Should everyone dollar-cost average? Is dollar-cost averaging more advisable for people with shorter time horizons--and in turn less of an ability to recoup from ill-timed purchases? Over how many months should one dollar-cost average? And how does market valuation factor into all of this?

'Things Often Turn Out Badly'
For financial advisor Sue Stevens of Stevens Wealth Management in Deerfield, Ill., the investor's time horizon is a key variable when deciding whether to invest a lump sum or dollar-cost average. "The longer you have to let the stock grow, the better. For a young person, you could just invest a lump sum instead of dollar-cost averaging. For an older person, I would look at when they will need to use that money. If it's in the next five years, for example, I might not invest it in stocks at all."

Other investment experts believe that an investor's sophistication level and past investing decisions should be key inputs when deciding whether to employ dollar-cost averaging.

Roger Wohlner, a financial advisor based in Arlington Heights, Ill., says, "The first question that I would ask clients is why they are so light on equities. I would listen closely to their answer, as it would tell me a lot about their investing philosophy."

Wohlner believes that investors who have a history of moving in and out of the market at poor times are the best candidates for dollar-cost averaging. "When an investor feels like they've missed out on the market and rushes into equities, things often turn out badly, at least in the shorter-term. Investors who feel like they need to get into the market at times like these may also be the ones who panic and get out at the wrong time," he said.

Ferri agreed that understanding investors' past behavior is crucial when deciding how to handle an equity-light portfolio. "If they're light on stocks because they sold during the crisis, then I would be very cautious in increasing their allocation in any manner," he said.

The investor's experience level also plays a role in Ferri's decision-making. "I would be cautious about increasing the allocation to stocks with someone who has little experience and less cautious with a person who has more experience."

Mean Reversion: On the Way?
Assuming an investor has decided to move forward with a dollar-cost averaging plan, the next step is to figure out the time frame for it. Should the dollar-cost averaging happen over six months? 12? Or an even longer time frame?

Ferri recommends anywhere from one to three years to execute a dollar-cost averaging program, depending on the investor and his or her comfort level. The more comfortable he or she is with taking risk, the sooner the money should be invested.

Previous studies have argued for getting the money invested as quickly as possible--ideally within the space of a year. That's not surprising given stocks' generally upward trajectory. But investment advisor Bill Bernstein, author of a new book called Rational Expectations: Asset Allocation for Investing Adults, notes that that conclusion was influenced by the time period examined--the bull market that prevailed for the better part of the 20th century.

"It's all so time-period-dependent," he said. "We think that five years is not a bad period for dollar-cost averaging, but which five years? The period from 2002 through 2007 [when stocks were heading up] was a crummy period to dollar-cost average in. On the other hand, 2006 through 2011 was a great time to dollar-cost average."

Bernstein's comments highlight the role of valuations in determining when--and for how long--to dollar-cost average. After all, valuations are the best predictor of market performance: high stock prices often foretell weak returns ahead, whereas low prices signal that strong returns are likely on the way.

"If you believe that the markets are going to significantly mean-revert back toward more reasonable valuations during the next five years, then dollar-cost averaging over that period is the right choice. I think that in the next several years there's a greater-than-usual probability of mean reversion."

"But," he warned, "I could be wrong."

Ferri believes that investors should only involve valuations in the dollar-cost averaging decision in extreme circumstances. "Valuation isn't important most of the time," he opined. "However, it can be important at the extremes and when an investor's time horizon is less than 15 years. I don't think we're at an extreme now, so it shouldn't matter."

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