Investing a Lofty Cash Stake in a Lofty Market

After a recent presentation, I spent some time chatting with an investor with a worry on his mind. He told me that he had pulled money from stocks a few years ago, but the market crash he had been expecting didn't materialize. Two years later--and two years closer to retirement--he was wondering what to do next. Was it too late to move the money back into the market? He couldn't afford to have so much of his portfolio earning next to nothing. On the other hand, he worried about his timing: Stocks were no cheaper now than when he made the shift into cash, and bonds--with their ultralow yields--didn't look a whole lot more appealing.

His predicament isn't unusual. At any given point in time many investors find themselves with larger cash hoards than they really need, due to market-timing decisions gone awry or windfalls like inheritances or home sales.

Some cash-heavy investors get lucky; their enlarged cash stakes coincide with a weak market environment. Putting money to work at such junctures takes mental toughness--what if the market hasn't bottomed?--but savvy investors know they'd rather buy merchandise on sale than when it's expensive.

On the other hand, deciding what to do with a big cash hoard is much more tricky after the market has already rallied a lot. While stocks have basically flatlined since the end of 2014, they're still up about 15% on an annualized basis since bottoming out in early 2009. Given that equity returns have averaged less than 10% over very long time frames, that's quite a run indeed. And while stocks don't look egregiously expensive on a bottom-up basis, nor are they a screaming buy: The typical stock in Morningstar's coverage universe is trading just above its fair value currently. And it's not like bonds have lost ground as stocks have rallied, as is sometimes the case. While bonds have certainly underperformed stocks since the market recovery began, declining interest rates have stoked bond prices over this period.

If you or someone you know is sitting on a lot of cash today but the current market environment is making you nervous, here are some key factors to consider.

Long Time Horizon Can Help Mitigate Poor Entry Point For those who are early in their investment careers, putting a lump sum of cash to work straightaway is usually the right answer. The reason is pretty straightforward: Both bonds and stocks have higher average returns than cash over long time frames, so the sooner the money gets invested, the more likely it is that the portfolio will be able to avail itself of that probable return advantage.

Even in a worst-case scenario--if the initial investment turns out to have been ill-timed and the investment loses money right out of the box--the portfolio's initial drop is apt to be at least partially offset by future market gains, assuming a sufficiently long time horizon. At the end of a 30- or 40-year period, the investor who mistimed his or her initial purchase may still be behind the one who invested at a better time, but their initial timing decisions are apt to get drowned out by other decisions down the line.

In a 2012 Vanguard study comparing lump-sum versus dollar-cost averaging strategies (that is, dribbling the money into the desired allocation slowly in fixed dollar amounts versus all in one go), a lump-sum 60% equity/40% bond portfolio outperformed the dollar-cost-averaged portfolio in two thirds of rolling 10-year time periods. And the longer the dollar-cost averager took to get the cash invested, the greater the odds that the lump-sum investment would beat the dollar-cost-averaging strategy, according to the Vanguard research. If it took an investor 36 months to get the money fully invested into the 60%/40% bond allocation, the dollar-cost averaging strategy underperformed the lump-sum investment in more than 90% of rolling 10-year time frames. (Financial-planning expert Michael Kitces explored the pros and cons of lump-sum versus dollar-cost averaging in this video and in this post on his blog.)

The case for deploying a lump sum right away is even stronger if an investor expects that she will be making further purchases down the line, as most young investors do throughout their investing careers. Even if the initial lump sum were deployed at a poor time, additional, more opportunely timed purchases would help offset the initial purchase miscue.

Lump-Sum Investing Riskier When Drawdowns Are at Hand But the case for taking a more deliberate approach grows more compelling if the investor's time horizon is shorter. Not only would big losses likely be psychologically jarring for an investor approaching retirement, but if stocks and/or bonds fall shortly after the money gets invested, the investor getting closer to needing his or her money would essentially have to lock in her losses. In short, a poorly timed entry point is less important with a very long time horizon (especially if additional contributions are to be made), but it gets magnified if the time to drawdown is short.

For example, an investor plowing $100,000 into the U.S. stock market at the beginning of 2000—at what in hindsight was a lousy time to do so—would have had about $217,000 at the end of 2015. Had that same investor sat in cash and waited until early 2003 to invest in U.S. stocks—after the bear market was over—she would have about $338,000 by year-end 2015. That's a giant differential over a fairly long, 16-year time horizon, simply because the 2000 entry point was so very bad, and would make a big difference from a quality-of-life standpoint for someone who planned to retire in 2016.

The trouble is, few investors would have had the presence of mind to begin investing in early 2003, after stocks had bottomed but fear was still running high. (The same was true in early 2009, after stocks reached their nadir following the global financial crisis.) That's where dollar-cost averaging comes in handy. Had the same investor deployed her $100,000 in $2,778 intervals over a 36-month period from early 2000 through the end of 2002, then let it ride after that, she'd have roughly $264,000 by the end of 2016. That's not as good as the return earned by the investor who waited until the market had bottomed to invest, but it's substantially better than the return earned by the investor who plowed all of her money into the market just before it dropped. In essence, the dollar-cost averager has split the difference. She admitted that she didn't know when stocks would drop and when they'd stop dropping, so she spread her bets around. (And in investing, admitting what you don't know can be very powerful.)

Automation Can Help Assuming an investor has decided to go forward with a dollar-cost averaging strategy--and there's a lot to recommend that approach if retirement is close at hand--a sensible next step is to automate those additional purchases with an automatic investment plan. One of the advantages of dollar-cost averaging is that investing consistent dollar amounts allows you to buy more shares when the market is down. But from a psychological standpoint, putting money to work in a falling market can be downright unappealing. Taking the step of putting those additional purchases on autopilot can add discipline to the process.