Dollar Cost Averaging: Are You Really Better Off?

Dollar Cost Averaging: Are You Really Better Off?

As I write this post the S&P 500 is about 100 points off it’s all time high of 2922, and climbing fast.  We’ve seen an incredible bull market over the last ten years since the last financial crisis, and many people are wondering whether the next crash is around the corner.

So if you’ve just come into some money that you’d like to invest, is now a good time?  What if you invest everything right before the market crashes again?  Should you wait?

One popular strategy used in this situation is dollar cost averaging.  Rather than invest everything at once or keeping your cash on the sidelines, dollar cost averaging parses out what you’d like to invest over time.  The idea is that stretching out your investing over a longer period protects your savings against crashes.  Basically, if the market does crash tomorrow you have less at risk.

For example, I have a client who just sold her business last year.  She’s expecting to live off the proceeds raised from the sale for the rest of her life.  We have a plan in place to help her accomplish this.

One of the big psychological hurdles we had to work through was how to go about investing this cash.  While my client needs portfolio growth to ensure she doesn’t run out of money, the proceeds from her business sale account for over 70% of her net worth.  Investing all of it at once was a nerve wracking idea!  So we decided to dollar cost average the funds over the subsequent 12 months instead.

 

Dollar Cost Averaging vs Lump Sum

After studying this stuff for a while, I know that my client is likely to have a better outcome by investing everything at once.  But that doesn’t help her sleep at night.  The idea that the years of toil in her business could be washed away in an instant by neurotic Mr. Market was unacceptable.  And even though she’s more likely to leave money on the table by holding back the cash during a growth period, this route made more sense for her.

Since then I’ve had probably half a dozen clients in similar situations.  They have cash, but are reluctant to put it all at risk at once.  While dollar cost averaging helps, I know intuitively that we’re more likely to miss out on potential returns than successfully avoid a crash.

But how much more likely?

There have been a few studies on this subject over the years (like Vanguard’s in 2012).  But with the research tools I use in my practice, I figured I’d run the analysis myself out of curiosity.  Especially since market returns since 2012 have been so strong.

I should also note that I grabbed the data for this post (and began writing it) back in December.  Business got in the way, and it’s taken me a couple months to finish it up.  Last month Nick Maggiulli of Ritholtz Wealth wrote a great post on the same topic.  Ordinarily I don’t like to write posts that are similar to others I’ve recently read, but here we are.  If you’re interested in the topic you should definitely read Nick’s post.

 

The Data

To start, I used the Morningstar US Market Index as a proxy for stocks and the Barclays U.S. Aggregate bond index for bonds.  I chose the Morningstar index because didn’t want to omit small & mid cap stocks by using the S&P 500.  I pulled monthly returns going back 20 years for both indices, including dividends & distributions.  20 years isn’t a tremendously long time, but it does capture the dot com bubble & bust, the mortgage crisis, and the last 10 years of market strength we’ve enjoyed.

Then I went to work calculating the returns of a 60/40 portfolio invested all at once, versus the same portfolio invested over a 12 month period using dollar cost averaging.  I ran the exercise using rolling 3 year, 5 year, and 10 year periods.

 

The Results

Three Year Rolling Periods

In the first “run”, I took a look at returns over rolling 3-year periods.  The first month of the exercise was October of 1999.  I looked at the 3-year cumulative return using the monthly returns of the 60/40 portfolio invested all at once.  Then I calculated the same 3-year cumulative returns of the same portfolio, but “dollar cost averaging in” over a 12 month period.

There were 203 different 3-year rolling periods.  Of those, investing all at once in a lump sum outperformed dollar cost averaging 153 times (about 75%).  On top of that, the total return of investing all at once was 2.65 higher, on average.

Dollar Cost Averaging vs Lump Sum Investing

I then separated the periods where one method outperformed the other.  Of the 50 periods where dollar cost averaging did outperform, it did so by about 6.24%, whereas investing all at once outperformed by 5.55% when it did better.

Dollar Cost Averaging vs Lump Sum

Dollar Cost Averaging vs Lump Sum

What was most interesting to me here is that of the 50 periods where dollar cost averaging did better, 42 (or 84%) occurred in the periods between Apr 2000 and July 2002, or June 2007 and October 2008.  Both these periods preceded major market crashes, of course.

You’ll also notice that I included the average P/E ratio and Shiller P/E ratio of the S&P 500 too.  Remember that the Shiller P/E is a cyclically adjusted ratio, using the market’s average earnings over the last ten years.  I included these metrics because it seems logical that dollar cost averaging would work better in periods of higher P/E multiples.  When the market is expensive, wouldn’t you want to invest little by little, rather than all at once?  When the market is cheap, wouldn’t you want to take advantage by investing all at once?

 

Five Year Rolling Periods

Looking at five year rolling periods instead of three, the result was similar.  There were 179 total periods over the 20 year span, and investing the 60/40 portfolio all at once outperformed in 135 of them (75.42%).  What’s interesting to me about this run is that investing all at once outperformed dollar cost averaging by an average of 2.65%.  This is identical to three year rolling periods above.

Dollar Cost Averaging vs Lump Sum

While the average P/E ratios are also nearly identical, the difference in returns was more extreme.  In periods where dollar cost averaging does better, it did better by a wider margin over five year periods: 8.16% instead of 6.24%.  When investing all at once does better, it beat dollar cost averaging by 6.6% instead of 6.24% over a three year period.

Dollar Cost Averaging vs Lump Sum

Dollar Cost Averaging vs Lump Sum

 

 

Ten Year Rolling Periods

The data from 10-year rolling periods was surprising to me at first.  Dollar cost averaging fared better here than either the 3 or 5 year rolling periods, outperforming about 32% of the time.

Dollar Cost Averaging vs Lump Sum

But after looking at the 20 year time period of data, the difference becomes understandable.  The whole point of dollar cost averaging is to keep some money off the table and spread risk over a longer period of time.  If the market does crash after your initial investment, you have cash on hand that hasn’t lost value AND can potentially buy stocks at lower prices.  And since the time period we’re viewing here is October of 1999 through October of 2018, the ten year rolling periods are book-ended by crashes.  The first ten year period began right before the dot com bubble crashed.  The final ten year period began in October of 2008, just as the mortgage crisis was materializing.

Dollar Cost Averaging vs Lump Sum

Dollar Cost Averaging vs Lump Sum

Notice the greater cumulative difference in returns here, too.  In the periods where dollar cost averaging does better than lump sum investing, it does nearly 11% better on average.  When investing all at once does better, it outperforms by about 8%.

 

Observations

So what do we get from all this?  The data here is similar to what the Vanguard paper concluded in 2012: that investing a lump sum all at once outperforms dollar cost averaging about two thirds of the time.  But that doesn’t mean that dollar cost averaging should be abandoned.  If your primary concern is reducing downside risk (or minimizing feelings of regret if the market does take a dive), dollar cost averaging might be a good idea.  You probably won’t be better off than if you’d invested everything at once, but if you’re transitioning into retirement perhaps downside risk is unacceptable to you.  In this situation though, I’d suggest devising a plan that manages sequence of returns risk before moving forward with a dollar cost averaging strategy.  There’s a good chance you’ll have a better outcome.

I was hoping that P/E ratios would tell us something useful too.  That wasn’t the case.  There’s a lot of debate around whether the P/E of the S&P 500 or the Shiller P/E ratios are indicators of future market performance.  Vanguard contends (and I agree) that they are over longer time periods.  Since the benefit of dollar cost averaging is reducing risk over the buy in period, which is generally no longer than 24 months, I don’t think I’d use P/E ratio when deciding whether to invest all at once.  There’s just no way to tell whether a market crash is coming over a 24 month period.

What do you think?  Have you employed dollar cost averaging in the past?  How has it worked for you?

The 7 Most Common Retirement Planning Mistakes

The 7 Most Common Retirement Planning Mistakes

Free Online Workshop

Hey Everyone! I'd like to invite you to our next live online event: The 7 Most Common Retirement Planning Mistakes.

Thanks to your feedback, we've put together a workshop that will cover the top mistakes I see in my practice and how you can avoid them.  We'll be hosting the workshop this coming Thursday, 4/26, from 10-11am PST / 1-2pm EST.

This workshop will be live, and if I manage the time correctly we'll have room for an open Q&A at the end.  So come prepared with retirement planning & investment related questions. 

This event will be free, but space is limited so grab your spot now while there's availability.

Here's the link to register.  

 

Topics We'll Cover:

  • The most common retirement planning mistakes & how to avoid them
  • A proven method for maximizing your Social Security benefits
  • Powerful tips for reducing your tax burden both now AND in retirement
  • How to maintain a comfortable lifestyle and ensure you'll never run out of money

As I mentioned, this will be a free online event but seating is strictly limited to the first 100 attendees.  Feel free to spread the word to your friends/family members/colleagues who might be interested, but make sure you reserve your spot before space runs out.

Here's the link to register again.

I look forward to seeing you there!

 

 

Family Business Succession Planning: 3 Best Practices & A Review of the Statistics

Family Business Succession Planning: 3 Best Practices & A Review of the Statistics

If you’re reading this post, you’re probably familiar with the statistics: the failure rate for second generation family businesses is very, very high. When you consider the fact that family businesses make up about 60% of the gross domestic product in the U.S., it’s easy to see that succession planning is a major issue facing business owners across the country.

Transitioning a family owned business to the next generation is challenging for many different reasons. This post will review the statistics on family business succession planning, cover three common problem areas, and offer best practices for navigating them.

 

Family Business Succession Planning: The Statistics

To get us started, let’s review the statistics and examine why thoughtful succession planning for family businesses is so important.

First off, only about 30% of family businesses even make it to the second generation.  10-15% make it to the third, and 3-5% make it to the fourth.  These numbers sound pretty low, but they’re only counting businesses run by families’ younger generations.  Many businesses are sold or merged, which I would argue isn’t a failure at all.

Additionally, according the Conway Center for Family Business, 40.3% of family business owners expect to retire at some point.  But of those planning to retire in less than 5 years, less than half have selected a successor.

That alone tells me that many failed successions are probably a result of poor planning.  In fact, other research from the Conway Center for Family Business tells us that 70% of family businesses owners would like to pass their business on to the next generation.  But only 30% are actually successful in doing so.

 

Common Succession Problems

Just to give us some context, the landscape of family businesses across the country is as diverse as our economy.  Family businesses cover all corners of industry in this country, and range in size from single person sole proprietorships to Wal-Mart.  There’s a lot of space in between those extremes.

Because of the large universe of companies, the specific problems impeding successful transitions is diverse as well.  Nevertheless, regardless of a company’s size, industry, profitability and other nuances, succession problems are usually tied to two fundamental issues: poor planning and long term family dynamics.

 

Entitlement & The Fall Back Plan

Through years of effort and grind, successful companies often produce significant wealth for founders and their families.  Whereas the founder may have developed his or her work habits out of necessity, their children are often brought up in a more comfortable environment.

This financial success also gives founders’ children far more options, and allows them to pursue whatever path they choose in their careers.  As great as this sounds, flexibility allows the children to treat the family business as a fall back plan, rather than an objective that they’ll need to work toward.

The downside here is pretty obvious.  Kids comes back to join the business, and are often propelled into management positions sooner than they should be.  Not only are they inexperienced and prone to make critical errors, but their career trajectory will undoubtedly alienate other employees.

Insisting on proper training and screening is a good place to start.  You can always give your kids an opportunity, but a job with the family business shouldn’t be an entitlement.  Family members should go through the same formal vetting process that other employees do.  Implementing a minimum education and/or experience requirement, and formalized training process is a good place to start.

Again – you can always give your kids an opportunity, but resist the temptation to thrust them into a leadership position.

 

Familial Ties vs. Diversity of Experience

In medium and larger businesses, it’s common for immediate family members to follow their parents to certain departments.  For example, let’s say a founder’s daughter is interested in finance and spends most of her career as the company’s CFO.  If her children park decide to pursue finance because of their mom’s influence, they often have a hard time developing the skills necessary for upper management.  Rather than blazing their own trail in an area of interest or gathering experience in multiple areas, younger generations often tend to go with what’s familiar.

The solution here is to try and minimize the amount that family members report up to each other.  All employees, family or otherwise, should be held to the same standards and expectations.  Business coaches and mentors can be helpful here as well.  Any way to offer outside influence, objective feedback, and accountability tends to help, and will prepare the next generation for management responsibility.

 

Business Size: Supporting the Family

Starting a business can be quite a challenge, and most founders spend a few years struggling to put food on their family’s plate.  As the business becomes more financially successful this tends to be less of a problem.  Once founders reach the point where they’re comfortable and have met all their financial objectives, many tend to take their foot off the gas, rather than continue to grow the company.

Now consider what happens when the founder’s children enter the picture.  If the founder has two kids, and both kids have two of their own, all of a sudden there are a lot more mouths to feed.  Whereas the founder was originally responsible for supporting four people (including the kids and his spouse), now the business needs to support 10!  To stay in the family long term, the business will need to generate a great deal more revenue.  If it can’t, it will need to merge, be sold, or fold.

To avoid this problem, all new employees should have a responsibility for growth.  This could be in the form of direct business development or preparing the business for scaling.  A good example might be a new family member that comes on board right after college.  They may not be experienced enough to interact directly with clients or develop business, but they could be responsible for updating the company’s CRM system to support more efficient growth.

 

Successful Family Business Succession Planning

It’s no secret that succession planning is a huge challenge for family-owned businesses. Family dynamics, communication, trust issues, preparedness of the younger generations, and different expectations for family members vs other employees can all contribute to problems.

There are far more causes to the low success rates than what we reviewed in this post.  The point here is that many of these issues can be solved or eliminated by prudent planning.  Experienced attorneys, accountants, financial planners, and bankers can all be valuable resources who can help you reach a desirable outcome.  If succession is in the cards for your business, the input of a qualified professional is often worth its weight in gold.

Market Volatility Survival Guide

Free Online Training: Market Volatility Survival Guide

If you’ve been paying any kind of attention to the markets over the last two months, you’ve probably noticed a new trend: volatility.  Consistent market volatility isn’t something we’ve seen in quite some time.  Other than the market’s brief reaction to the Brexit, we really haven’t seen much upheaval since the depths of the financial crisis.

With tighter monetary policy from the Federal Reserve and both feet on the gas of our fiscal policy here in the U.S., there’s a good chance the choppy waters are here to stay.

Since I’ve been getting a ton of questions recently about how to handle market volatility, I figured it’d be a good subject for an online training.  So, this Tuesday, March 6th, from 10-11am PST / 1-2pm EST, I’ll be hosting a free online training on how to protect your retirement accounts during market corrections.  Here’s the link to register.

Topics We’ll Cover:

  • The single BEST strategy to protect your retirement portfolio when markets crash
  • The secret to surviving the next bear market
  • The top 5  mistakes you should avoid when saving in workplace retirement accounts
  • How to tune out the noise and identify what news you should actually pay attention to

This will be a free online event, but seating is strictly limited to 100 attendees.  Feel free to spread the word to your friends/family members/colleagues who might be interested, but make sure you reserve your spot before the spaces are filled.

Click Here to Register

I look forward to seeing you there!

State of the Blog 2018

2018 State of the Blog

As I look up at my calendar and see that we’re already in February, I’ve come to a surprising realization: Above the Canopy is almost two years old!

Unlike most birthday parties for 2 year olds, I thought it’d be a good idea to nix the pizza, birthday cake, and screaming children in favor of a new tradition: an annual “state of the blog” post.  Above the Canopy has come quite a long way in its short life, and I’d like to take this opportunity to touch base with you, the readership, on the state of the blog.

 

The State of the Blog

The state of the blog is strong!  Overall I feel pretty good about Above the Canopy.  Especially considering the challenges of balancing new content with the needs of a small business.  As you may know, I spend most of my waking hours building & managing my financial planning business, Three Oaks Capital Management.  And as it turns out, growing a small business is a massive job.  Between that and family life I’m not quite able to give Above the Canopy the attention that I’d really like to.

Nevertheless, there’s a lot that I’d like to do with Above the Canopy.  And despite the demands on my time, readership is is growing at a strong clip.  Over 7,000 visitors found the site last month, which is over a 100% increase from January of 2017.

On the year, we had 47,446 visitors to the site vs. 12,925 in 2016.  (Keep in mind that the blog launched in April of 2016 though, so it was a short year).  As far as posting went, I managed to publish 30 times in 2017 vs. 38 in 2016.  Not as frequently as I’d like but hey, I’m learning as I go here.

 

Looking Ahead

There are several things I’d like to improve on the site in 2018 and beyond.  I’ll cover them below by listing each individual objective.  My hope is that communicating them will give you some insight into where the blog is headed (and give me a little more pressure to get them done!).  And as always, I’d love some feedback on what you enjoy about the blog, what you don’t, and what you’d like to see in the future.  Feel free to share in the comments.

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Backdoor Roth Conversion: How to Contribute to a Roth IRA When You Make Too Much Money

Backdoor Roth IRA Conversion: How to Contribute to a Roth IRA When You Make Too Much Money

If you asked me to choose my FAVORITE type of account to invest in, it would definitely be the Roth IRA.  Roth IRAs allow you to save money tax free for the rest of your life.  They’re not subject to mandatory withdrawals in your 70’s, and your kids won’t even owe taxes on their withdrawals if they inherit the account from you down the road.  In my opinion the Roth IRA is just about the best deal out there.

Problem is, they’re not accessible to everyone.  The IRS considers Roth IRAs such a good deal that they won’t let you contribute to one if you make too much money.  Fortunately, there’s a work around: the backdoor Roth IRA conversion.  The backdoor Roth conversion allows you to get money into the Roth IRA by making non-deductible contributions to a traditional IRA.  Don’t worry if this sounds complicated.  We’ll go over the strategy step by step in this post.  Read on to learn more.

 

The Backdoor Roth IRA Conversion Strategy

So here’s how it works.  I’ll break it down into two-distinct steps.  But to start, let’s review the income limitations for direct contributions to a Roth IRA.  If your modified adjusted gross income on the year (MAGI) falls below the “Full Contribution” threshold, you can contribute to a Roth IRA directly.  If your MAGI falls into the phaseout region your contribution limit for the year begins to fall.  When it reaches the “Ineligible” threshold, you’ll be prevented from contributing to a Roth IRA altogether (at least in 2018).  If this is you, the backdoor Roth conversion might be a good fit.  (Here’s a review of how to calculate modified adjusted gross income).

Backdoor Roth Conversion: How to Contribute to a Roth IRA When You Make Too Much Money

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Bloodletting and Evidence Based Investing

Bloodletting and Evidence Based Investing

Have you ever heard the term “bloodletting”?  Bloodletting was a tactic used by the medical community to prevent or cure illness.  In the old days, the collective wisdom was that our blood was one of many systems in our body that must remain in balance at all times.  If you walked into a doctor’s office with a common affliction like the flu or a cold, the doctor might determine that you simply had too much much blood in your body.  A common prescription was to apply leeches to your skin to bring relief.

Why did they believe this craziness worked?  Their anecdotal experience, speculation, and conjecture.

So how did we figure out that bloodletting was probably doing more harm than good?  Researchers began applying science to the practice of medicine in the late 1800s.  The scientific method of hypothesizing, gathering data, testing, and using analysis to come to a reasonable conclusion helped us figure out that our problems were not because we had too much blood.  They came from other things like viruses, bacteria, and our genetics.

 

Evolution of Investing

This revolution in western medicine is similar to what we’re seeing in investing today.  For years and years the investment process has been driven by anecdotal observation and conjecture.

For example, how many times have you read an article in Forbes or The Wall Street Journal that profiles the “next big stock to pop”?  In the 90’s it was tech stocks, in the 2000’s it was banking and pharmaceuticals, and since then it’s been social media and tech stocks.  Buying a stock that you think is about to pop, or is undervalued, has been one of the preeminent investment strategies since the early 1900s.

The same goes for “tactical” asset allocation.  Boosting your portfolio’s allocation to oil stocks because you think OPEC is about to cut their production quotas, or selling bonds because you think interest rates are about to rise are strategies based on speculation about the future.

Why do so many people invest this way?  Because of our life experience & anecdotal observations.  Everyone I’ve ever met has at least one person they know who invested early in Facebook or Microsoft and made a fortune.  We believe this type of investing can work because of our anecdotal experience.

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The Equifax Data Breach & Why We Should Care

The Equifax Data Breach & Why We Should Care

I’m sure by now you’ve seen the headlines: Equifax had a data breach and a bunch of Americans’ personal information was stolen by hackers.  It’s easy to ignore incidents like these because they’re becoming more commonplace.

The incident with Equifax is a bigger deal, though.  Past incidents like Target and Yahoo have included important pieces of sensitive information, but never the whole picture.

The Equifax breach included names, Social Security numbers, birth dates, addresses, and some credit card numbers.  That’s enough information to take out a loan in your name, rack up credit card charges, claim your tax refund, or even withdraw money from your bank account.  And it happened to 143 million Americans.  That’s 44% of the population.

I’ve gotten a few questions about the Equifax breach this week, so I thought a blog post might help answer a few of them.  This post will cover what happened, why it’s important, what you should do now, and why you shouldn’t trust that they’ll “make things right”.

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Paying for College With Your 401k: Can You? Should You?

Paying for College With Your 401k: Can You? Should You?

Believe it or not, we’re already in “back to school” season.  And to continue our recent series of posts on paying for college, today’s covers a question I’m sure will resonate with many readers:

Should you raid your 401k to pay for your kids’ college?

There are a lot of moving parts to this question.  First, can you even get money out of your 401k to pay for college costs?  Are there early withdrawal penalties for doing so?  And aside from the logistics, is it even a good idea to?  This post will cover whether it’s possible…and whether you should.

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Using a Roth IRA for College Savings: What You Need to Know

Using a Roth IRA for College Savings: What You Need to Know

If you’re in a position to put some money away for your childrens’ future college costs, a 529 plan is typically the most popular home for your savings.  There are some tax advantages, you could get a deduction on your state’s income taxes, and heck, the accounts were created for college savings.  But the knock on 529 plans is that they can be inflexible.  Take money out for anything other than qualified educational expenses and you’re probably looking at a 10% penalty on the account’s earnings.

As an alternative, some people prefer to use a Roth IRA for college savings instead.  You get great tax benefits, and many people don’t realize that you can withdraw funds before retirement age penalty free if they’re used for qualified educational expenses.  So given the limitations of 529 plans, are Roth IRAs really a superior vehicle for college savings?

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