- Strategies for investing lumpy income streams
- Dollar Cost Averaging — making fixed, periodic investments
- Enhanced Dollar Cost Averaging — investing a fixed additional amount after down periods
- Value Averaging — fixed amounts of value put into the investment over time
- A comparison of the strategies
- Potential disadvantages
- Psychological benefits
- The Fine print
Many investors we speak to express concerns about rich market valuations, and anticipate a correction or a bear market in the near future. We believe that pullbacks in equity market performance are normal and expected throughout this market cycle. While the economy is growing and monetary policy is accommodative, we do not anticipate a prolonged bear market. (See SVB Wealth Advisory Market Outlook - Q3 2015).
Nevertheless, we appreciate that some investors feel stress and regret if equity markets drop sharply after investing their cash. Therefore, we commonly review with our clients various methods of "getting cash to work" so that they can
- evaluate potential outcomes
- develop specific plans to invest their cash, then
- implement those plans with discipline.
We find that those clients who adopt a disciplined approach are more comfortable with the long term results, which they should be more focused on, regardless of the short term outcomes.
A sample of regular periodic purchases during a volatile market period.
Strategies for investing lumpy income streams
This article outlines three strategies that could be utilized by investors as alternatives to the common approach of lump sum investing. Unlike traditional investors, technology entrepreneurs and investors usually have "lumpy" income streams, periodic large cash inflows, and significant "boulders" in their portfolios representing their illiquid private holdings. All of these factors contribute to a non-traditional "barbell" portfolio that may be heavy in cash on one end, and in high-beta concentrated private holdings on the other end. It's unusual for these investors to make periodic investments into vehicles such as company 401(k) plans or stock purchase plans in order to weather the ups and downs of the markets.
When presented with the opportunity to invest a lump sum from a windfall event such as an IPO, an acquisition, or a venture fund distribution, the entrepreneur-investor must choose not only what to invest in, but also when and how to enter the market. We find that many people try to time the market by finding the optimal point of entry. As this has historically been extremely difficult to do, investors may experience either a high opportunity cost or regret, leading to abandonment of the strategy.
In the analysis below, I describe three strategies that can offer distinctive advantages to a lump sum investing approach:
Strategy 1: Dollar Cost Averaging — making fixed, periodic investments
The first strategy is Dollar Cost Averaging (DCA). It is a fairly well-known approach which involves making fixed, periodic investments into a portfolio or a security. The main benefit of DCA is that it averages the cost of the investments, and allows the investor to buy more shares when the price of the security drops and fewer shares when the price rises. Thus, the average cost paid per share is usually lower than the unweighted average share price during the investment period, and usually less than the price of a more risky purchase with a lump sum. Some of the other advantages of DCA are its automated nature, low initial capital requirements, and the lack of need for market forecasts.
Here is a simple example of how DCA would work: if an investor invested $1,000, in an exchange traded fund that tracks the S&P 500® index every month from October 2007 (the peak before the recession in 2008) through July 2015. As the market dropped severely in 2008 and the beginning of 2009, a DCA investor would have been purchasing securities at a discount, rather than only holding a previously existing lump sum position and hoping for a market pick-up. That investor would have seen a total cumulative return of 60%, compared to just 37% with a lump sum investment invested in the market at the onset of that period.
The chart below provides another example of how Dollar Cost Averaging would work with a quarterly investment of $1,000 over one year (excluding commissions or other investment fees).
Strategy 2: Enhanced Dollar Cost Averaging — investing a fixed additional amount after a down period
The second alternative is a variation of DCA, known as Enhanced Dollar Cost Averaging (EDCA). It emerged as the Dollar Cost Averaging approach was criticized for ignoring available new information and not being market-tuned. To improve on DCA, EDCA takes into account new information — that positive returns make stocks more expensive and negative returns make them cheaper — when determining the dollar amount of the subsequent periodic investment. EDCA attempts to resemble a more optimal sequential strategy. Thus, EDCA strategically invests a fixed additional dollar amount after a down period (e.g. a month or a quarter) and reduces the investment by a fixed amount after an up period.
For example, if our investor invested $1,000 into a security in quarter 1 and the security had a negative quarterly return, rather than investing another $1,000 in quarter 2 (as in DCA), the investor would invest $1,500 into the market in quarter 2 ($500 being the specified additional dollar amount). If the subsequent quarterly return of the portfolio was positive, the investor would invest only $500 for that period (= $1,000-$500), investing more during lower price periods, and less during higher price periods.
Here's another example of EDCA using the same overall investment cost as Table 1. You can see the difference the strategy can make when looking at the lower average cost per share in Table 2 (EDCA) compared to Table 1 (DCA).
Studies comparing DCA and EDCA find that EDCA tends to outperform DCA, and usually delivers higher dollar-weighted returns and greater terminal wealth, especially when investing in higher volatility portfolios. At SVB Wealth Advisory, depending on the client's situation, we may employ a variation of this strategy, discussing the amounts of the periodic investment tranches with our clients on a periodic basis.
Strategy 3: Value Averaging – fixed amounts of value put into the investment over time
The third alternative strategy is Value Averaging (VA). Both VA and DCA make periodic investments rather than investing a lump sum up front. The major difference:
- DCA requires a fixed amount of money put into a stock over time
- VA requires a fixed total value added to the investment over time
In Value Averaging, the goal is to increase the total value of the investment by a fixed amount at a regular interval, by either buying or selling. For example, the goal would be to increase the total investment in that stock, from $1,000 to $2,000 from quarter 1 to quarter 2, and from $2,000 to $3,000, from quarter 2 to quarter 3. If the VA strategy begins by purchasing a stock at $50 per share, the VA investor would purchase $1,000 in quarter 1, buying 20 shares at $50 per share. But, rather than investing a fixed $1,000 in the next quarter, the VA investor invests the specific amount that will result in a total value of $2,000 (a $1,000 increase in total value) at the current stock price in quarter 2. This approach requires a bit more calculation than merely investing a fixed dollar amount in the stock, because the investor must determine how many shares must be purchased at the current stock price given the current value of the holdings to raise the total value by the chosen increment.
Let's say that in quarter 2 the stock is trading at $53. If the total value increase target is $1,000 per quarter, then the VA investor must purchase almost 18 shares to reach a total holdings value of $2,000.
Here is an example using the VA strategy to reach a total investment value of $4,000 during a year:
Note that this method allows for both buying and selling of the security to reach the incremental value targets. VA may also be modified so that no sales occur with future value increases. Although VA could arguably produce higher average dollar-weighted returns than the alternative strategies by being more aggressive, its practical applications are more limited given that the total amount to be invested isn't known when starting the investment program.
The VA strategy does require more monitoring, may cause a higher turnover of shares, and could create more significant tax consequences. These are the result of having to realize short-term capital gains by selling when the total value exceeds the target amount. VA also has a higher capital loss potential because the amount required to be invested is unconstrained, therefore there may be more capital at risk.
Which strategy should you choose?
There are several reasons why periodic investing strategies are extremely compelling. The shorter the time horizon of the investor, the lower the risk tolerance, and the larger the portion of the overall balance sheet at stake, then the more beneficial these strategies can be in delivering a possible higher risk-adjusted return. These strategies focus on the risk management of an investor's portfolio, rather than simply excess returns. We find that, as our mandate with many clients is to reduce the risk in their portfolios rather than to compete with their existing potential for outsized returns in their private holdings, these gradual investing strategies to ease into the market provide a valid alternative to up-front investing.
Here is a comparison of the characteristics of these three strategies to help you choose the best strategy to suit your personal situation:
One key to the successful use of any averaging approach is executing the strategy in an appropriate time period to deploy the capital in the investment. The majority of the studies we reviewed agree that, when averaging into a higher volatility asset class such as equities, a minimum of one year is needed in order to avoid a potential short-term positive or negative market correction. The benefits of such strategies could significantly dissipate if the investment period is longer than three years, in which case an up-front investment could often outperform. This is due mostly to the opportunity cost of staying on the sidelines in a potentially lower-yielding asset class such as cash.
This brings up another conclusion: gradual investing strategies tend to add less value when applied to lower-risk asset classes such as bonds. At SVB Wealth Advisory, depending on the client's needs, we often recommend using averaging strategies when deploying capital into the equity portion of the portfolio and making an up-front investment in the bond and liquid alternatives asset classes. Long-term investors should consider employing lump-sum, buy-and-hold strategies for lower risk assets, and invest in them as early as possible. They should reserve averaging strategies such as DCA, EDCA, and VA for higher risk assets.
It is also important to mention some potential drawbacks of these strategies when comparing them to a lump sum investment approach. There is the obvious opportunity cost caused by a delay in investing if the portfolio is dominated by assets (i.e., stocks) which traditionally have outperformed the alternatives (i.e., cash) most of the time. In addition, periodic investing strategies could carry transaction costs, tax consequences, and may prevent investors from accessing some managers who require higher minimum initial investment amounts.
Lastly, most of these strategies do require some level of oversight. As with lump sum investing, there are potential behavioral traps in having a periodic investment plan that calls for some level of commitment in execution. It is possible for an investor to either abandon the plan, or accelerate it unnecessarily. An overlay of professional investment management may be key for the successful attainment of the investor's goal.
Psychological benefits – Investor, know thyself
All these strategies offer discipline of execution and thus provide important psychological benefits to aid investors in simply starting a personalized investment program. We find that, among technology entrepreneurs and investors whose balance sheets are often skewed towards private stock or cash, or both, building a diversified liquid core portfolio is paramount to achieving their wealth planning and accumulation objectives, and to reducing the risk in their current exposures.
Using DCA, EDCA, or VA, investors may not hit many home runs, but they could put together a winning string of singles and achieve a respectable score over time. By no means do we suggest that these three alternatives are the optimal strategies, but they are superior to the behaviors of many investors to be overly aggressive, overly conservative, or to try to time the market.
These strategies are like having a GPS while driving in unchartered territory – there is a route and a plan the investor could follow to avoid potential pitfalls. Furthermore, choosing to work with a professional investment advisor to execute these strategies would be like catching an Uber ride or hiring a chauffeur to help get to a desired destination in a faster, more convenient, and hands-off way. At the end of the day, it is all about either having self-trust or finding someone else to trust with portfolio management.
If you'd like to discuss how these strategies could work in the current market climate, please email us at firstname.lastname@example.org. We'd be happy to discuss.
The Fine Print
This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice, nor is it to be relied on in making an investment or other decision. You should obtain relevant and specific professional advice, before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction. Past performance is not a guide to future performance. Opinions and estimates are as of a certain date and subject to change without notice.
All investments and investing strategies are subject to risk. The performance of an index is not an exact representation of any particular investment, and one cannot invest directly in an index. Dollar-cost averaging and other averaging strategies do not guarantee that your investments will make a profit, nor does it protect you against losses when investment prices are falling. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives. Transaction and tax costs of your investment may affect your returns.
All material presented, unless specifically indicated otherwise, is under copyright to SVB Wealth Advisory, Inc. and its affiliates and is for informational purposes only. None of the material, nor its content, nor any copy of it, may be altered in any way, transmitted to, copied or distributed to any other party, without the prior express written permission of SVB Wealth Advisory, Inc. All trademarks, service marks and logos used in this material are trademarks or service marks or registered trademarks of SVB Financial Group or one of its affiliates or other entities.
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