Is it better to dollar cost average or invest a lump sum. And what type and how much life insurance should you buy.
In this episode you’ll learn:
- Should you invest large sums all at once, dollar cost average or go buy something.
- Why rational investors don’t dollar cost average, but most investors do it anyway.
- How term insurance works.
- How much life insurance should you have.
- How insurance companies are organized and make money.
- Under what circumstances should you buy whole life or universal index life insurance policies.
- How to plan financially for an expected inheritance.
Show Notes
Joshua Sheats – Radical Personal Finance
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Summary Article
Should You Dollar Cost Average?
On occasion as I worked with not-for-profits as an investment advisor they received large gifts that comprised a meaningful percentage of the institution’s assets.
The board of these institutions needed to decide what to do with the money.
Should they invest it all at once in a lump sum or should they average into the market over a period of time?
This incremental approach is called dollar cost averaging.
Why Dollar Cost Averaging Underperforms
I’d show these boards historical studies that indicated the lump sum approach was superior to dollar cost averaging.
The logic was simple. The stock market appreciates over time so investing in a lump sum will statistically do better over most periods than averaging in because the dollar cost averaging approach will miss out on some of the early months of appreciation.
Of course, if the stock market trends down in the early months of the investment, then dollar cost averaging will perform better than investing the gift in one lump sum.
Why Most People Don’t Dollar Cost Average
Most of the time the board would dutifully look at the studies, acknowledge what the statistics said, and then choose to dollar cost average.
Why?
They feared having to answer to the donor if the stock market plummeted shortly after the gift was invested. That would look imprudent in their opinion.
These boards were using the simulation heuristic—a concept first developed by Daniel Kahneman and Amos Tversky. The simulation heuristic says people determine the likelihood of an event based on how easy it is to form a mental picture of it.
It was much easier for these boards to visualize a donor upset about his or her gift falling in value by twenty percent shortly after it was donated than it was to imagine the donor upset because the gift didn’t appreciate as much using dollar cost averaging than it would have had it been invested in one lump sum.
The Power of Regret
Even if the donor didn’t care either way, the regret the board would have felt having lost money investing a lump sum would be more intense than the satisfaction they would have felt had the market appreciated dramatically after the institution invested the gift.
Regret can be a powerful motivator and will usually override statistics when it comes to investing.
Acclimating To A Larger Portfolio
When individuals receive an unexpected gift or an inheritance, they will often do the same thing as these not-for-profit boards. They will dollar cost average into the market rather then invest a lump sum.
I have no problem with this. I do the same thing.
When individuals receive a large addition to their portfolios, it can take time to get used to managing a larger sum of money.
The numbers are bigger and it feels like there is more at stake, even if the new funds were an unexpected gift or inheritance.
Dollar cost averaging can help ease the transition.
The emotional benefit of dollar cost averaging usually trumps the rational analysis that says investing the new assets in one lump sum is statistically the better performing option.
Transcript
Welcome to Money for the Rest of Us, a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host David Stein and today is episode 79. It’s titled “Lump Sums and Life Insurance”.
Unexpected Lump Sums
In the early 1990s I was living with LaPriel and we’d just had our oldest son. We were living in Dayton, Ohio, and I was working in corporate finance. I worked for a captive leasing company that leased computers, ATMs, and other point of sale equipment. NCR was the company. They later got bought out by AT&T, and so I worked for AT&T Capital Corporation. Pretty much corporate finance. I had my undergraduate degree in finance.
My graduate degree was in finance, but I was by no means any type of investment advisor or financial planner. Still, I had a friend ask me to meet with a recently widowed woman whose husband had died unexpectedly. She was in her 30s and this friend was worried about some of the financial decisions this woman was going to make with her life insurance. Her husband had died suddenly. She received about $500,000 in life insurance, a lump sum.
Now, at the time, this was a revelation to me. I did not realize that life insurance, at least in the U.S., when you receive a pay-out, it’s tax free. So, she literally had $500,000, where before they had a fair amount of debt and had been living probably somewhat paycheck to paycheck.
I went in a little trepidatious. I hadn’t really known anyone whose spouse had passed away. They had three or four children under 10 and I think they had a couple of teenagers. So, I went in, a little trepidatious, and I met with her. I just kind of wanted to see, basically, how was she going to invest this $500,000 in order to sustain herself, to meet their lifestyle and to meet the expenses of their children, et cetera.
As I got to speaking with her, and my friend was with me, it became pretty clear that she had very much made up her mind what she was going to do with these life insurance proceeds.
She was first going to pay off their debts and, second, she was going to buy a house, and not just any house. She was going to buy about a $300,000 home and pay cash for it. We had just moved into our first house. We’d paid $70,000 for this house built in 1940, and spent most of the summer working on it, trying to paint it, et cetera. I mean, a $300,000 house, that seemed like a lot of money to me in my late 20s. I talked with her, and there was no dissuading her.
Her viewpoint was here’s a chance for a clean break. I can be completely out of debt. We can live in a really, really nice home. My kids are having a tough time. We just need a fresh start in a brand new house, and that’s what I’m going to do, and I’ll worry about figuring out how I’m going to live. I own the house, so I know I don’t have a mortgage, and I’ll make enough in my job to pay taxes, and we’ll live from there. That was her decision.
How Much Should I Spend Now?
As I thought about that, there wasn’t anything I could say. It’s just, “Okay. I’m not going to dissuade you from that.” It brings up the question, what do we do with unexpected lump sum payments? I’ve seen this situation before. When individuals receive a lump sum, they often want to spend at least a portion of it, and I’ve come to believe that that’s actually a good thing. When my father-in-law passed away, my mother-in-law went and did some things on her home that she’d been meaning to do for years, new curtains, I don’t remember all what.
Sometimes when you receive a lump sum you just have to spend a portion of it. Now, hopefully not 80% of it on a new house. I’m not sure how this story turned out for this woman. I assume they were fine. They enjoyed their house and they had a wonderful life.
The question that comes up is, what do we do with a lump sum? Yeah, we’re going to perhaps spend something, go on a trip, buy a car. I mean it depends on how big the lump sum is. I recently looked at a survey that they did in Germany in 2000. (I think the government ran this survey). It was just asking people if you received more than $1,000 unexpectedly in Deutsche Marks–it was Deutsche Mark before they adopted the euro–how would you spend it?
Only about 30% would put it into savings. Most of the people said they’d spend it on a vacation. They would pay down debt. They would buy something for their home, do a remodel, buy just regular expenses. Now, 1,000 Deutsche Mark in today’s dollars, that’d be, well, at the time the exchange rate was two to one, so $2,000. So, not a ton of money, but an unexpected large sum.
It’s normal to want to spend something, but then I’ve gotten this question a lot from listeners regarding what do you do in terms of investing a lump sum, an unexpected or a large lump sum, maybe even expected.
All At Once or Bit by Bit?
In our case I sold my firm to my partners and every December I get a lump sum payment, and then I have to decide what to do with it, because one of the big question is, is it better to invest it all at once, so boom, you invest a lump sum, or is it better to dollar cost average, where you periodically, let’s say, monthly or quarterly invest a portion of those funds.
Now, this is a question that I often ran into as an institutional investment advisor, because we worked with mostly not-for-profits who were doing fundraising and occasionally they would get a very, very large gift as a percent of their endowment. The board would be faced with a decision: should we invest this lump sum all at once? We have our investment policy. We have our target allocation. Should we put it all in at once or should we dollar cost average and put it in over time? Now, most of the academic studies you look at say it is better to invest it all at once, that you just put it in, you buy and hold. You put it in with your investment policy and that’s what you do.
That’s what the rational investor will do. Why is that? Well, because markets, stock markets, over time tend to go up. So, the idea is if you are dollar cost averaging in and the market continues to go up, you’re continuing to buy stocks at higher and higher prices. So, your performance will be lower dollar cost averaging than it will if you do a lump sum payment or just buy it all at once. Now, if the market is trending down, dollar cost averaging, in that case, works, but generally speaking the market is trending up.
Then I read a paper by Moshe Milevsky–and I’ve mentioned him before; he can write some really interesting papers–and Steven Posner. It’s called “A Continuous Time Reexamination of the Inefficiency of Dollar Cost Average”.
You know where their bias or their conclusion is: that dollar cost average is inefficient, as I discussed, and I gave you the simple reason why: because markets go up. They did the same thing, but they had this third category where they used a technique, highly mathematical, called Brownian bridges.
I read the paper. There was a lot of math, and you know, as I’ve mentioned before, when it comes to academic papers, I read the beginning, I read, I skim through the middle and I read the conclusion. I skim most of the math because I don’t understand it. Now, that means I have got to put a lot of faith in whoever wrote the paper, which is why I tend to read authors that seem like they have a lot of credibility.
They concluded that if the market is going to stay the same that it’s better to dollar cost average in. In fact, the higher the volatility of the market and at the end of the period it’s at the same point as at the beginning, then dollar cost averaging is better. They used these Brownian bridges to figure that out. Maybe some of you can understand it. I know Alex, Alex a listener in Thailand, he’s got a PhD in mathematics, he probably could understand this paper. I’ll link to it in the show notes.
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