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.
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.
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.
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.
Rationale vs Emotions
The bottom line is dollar cost averaging mathematically suggests you shouldn’t do it when you have a lump sum. Yet, I’ve seen with these endowments and foundations they had a really hard time doing that, because, yes, we have the rational person that says, “Yeah, the numbers say don’t dollar cost average. Put it all in at once.” But we have the emotional investor, and think about a board of an endowment that gets this money from a donor, oftentimes the donor is still alive, and their biggest fear is they’re going to put the money in and the market’s going to fall 30%, and they’re going to lose 30% of this donor money and they’re going to be absolutely embarrassed.
We have no idea what’s going to happen, but that is their fear. It’s a legitimate fear, and so most of the time even though the numbers said put it all in at once, the board would make the decision to dollar cost average in, because their regret, the fear of regret of making a mistake and losing the money and being embarrassed on behalf of the institution and the donor, overrode any type of financial argument.
We make a lot of decisions that are not optimal from a rational perspective. One of the things I’ve seen with lump sums: now, within an institution, they had an investment policy. They had a target allocation and they weren’t sitting there trading or seeing … They see the balances in their report, but they didn’t have to invest it themselves.
As an individual when you receive a lump sum payment, or every December when I receive it, suddenly if you’re going to invest it according to your target allocation, your trades, the size of your trades are a lot bigger. By trading I’m not talking about daily trading. I’m just saying when you go out and you invest it and you go buy an ETF or an index fund, or an active mutual fund, it’s a lot of dollars that’s suddenly going in. It’s been my experience there is a psychological hurdle. It just takes time to get used to dealing with larger dollars and seeing the volatility of larger dollars from day-to-day.
I can tell you, I don’t invest lump sums all at once. I average in over time, as I get comfortable with seeing those bigger dollars, seeing the bigger trades, seeing the day-to-day volatility, and that’s how I handle it irrespective of what the numbers say, because I have to live with myself. I have to deal with the emotions and doing it little by little makes it easier for me to be a better, more disciplined, long-term investor.
Thinking About Life Insurance
Let’s just switch gears then. That’s what to do when you receive a lump sum payment. I often get asked how much life insurance should you have and what type of life insurance should you buy.
Back in college, as I mentioned, I studied finance, and I remember one student presentation. I don’t even remember what the class was. I know it was not a class on financial planning, and it was not a class on life insurance, but there was an student that was giving a presentation on life insurance. I thought, “This is really, really odd,” because this has nothing to do with the class, and I don’t even remember what the class was about.
All I can remember from his presentation is this phrase “buy term and invest the difference.” He was as a college student was an insurance agent, and this 20-year-old kid sold insurance for this company called AL Williams. They were an insurance company that encouraged people to buy term insurance. Term insurance is just plain, vanilla life insurance. You pay a premium on a quarterly or annual basis for, let’s say, a 10 or 20 year period, and the company promises to pay you a set death benefit if you die.
There cannot be any more simpler insurance, and the thesis was you just buy term, the premiums are relatively inexpensive compared to other more complicated insurance, and then you handle the investing of your additional money, the money you save in premiums by not buying, let’s say, a whole life policy, or universal indexed life. You can do better investing on your own. That really resonated with me. That makes sense to me, and so I’ve always had term life insurance. We have about a million dollars in life insurance. I bought it 15 years ago.
The other thing I remember from the presentation is you don’t need life insurance the rest of your life. You need it during your prime income earning years, and eventually hopefully you’ll have enough savings and investment that you don’t need life insurance when you’re in your late 50s or 60s.
This was sort of conventional, and this made sense to me and so I always swore off any type of complicated policies. In terms of how much life insurance to have, the idea was you needed to replace your income. If I was the primary bread earner, then if I died, I would want enough life insurance to take care of my kids and to help out LaPriel. That’s the logic I use.
With a million dollars, if we assume we could earn 4-5%, that would be $40,000 to $50,000 per year, which is a long-winded way of saying I was woefully under-insured as I think about it going back. It would not have been enough, and so that’s one of the things you have to think about: what are you going to earn. What can you earn when you receive this tax-free death benefit to take care of your dependents, or your family, et cetera?
Term life insurance is still relatively inexpensive. I think our premium is, we pay about $350 per year for $500,000. Rates are lower right now, in terms of insurance rates, so those premiums are probably higher just because insurance companies can’t earn as much money.
I’m not a financial planner, but I would think most people would want at least a million to two million dollars’ worth of life insurance. You’re looking for income replacement. That was my view on life insurance.
Understanding Different Types of Insurance
Yet, for many years I’ve gotten questions from listeners regarding other types of life insurance policies, such as whole life and situations indexed universal life. I’m not an insurance expert. My view has always been separate out your investing from your insurance, because insurance companies they’re set up very simply.
They have the asset side of their balance sheet, which consists of primarily their investment portfolio. Then they have the liability side of their balance sheet, which are their promised benefits to policyholders, and then also on that side of the balance sheet they have what’s called the surplus. On the left you have the assets. On the right you have the liabilities and the surplus.
The surplus is the value of the assets above and beyond the liabilities. The surplus serves as a buffer in case the insurance company doesn’t charge enough premiums, people live much longer than they expected, or just something to protect the policyholders.
There are two types of insurance companies. There are mutual insurance companies that are owned by their shareholders, and so the profits go to the shareholders, the owners of the policy, the policyholders. They get the profits. For profit insurance companies, the profits go ultimately to the shareholders that own the stock and the stock falls under the surplus.
How does an insurance company make money? Well, if you look at their income statement, their primary revenue is premiums that they receive and then the income they receive on their investments, and sometimes they realize gains. That all falls under income.
Their expenses are benefits that they pay out. As people die, they pay out the benefits. Obviously they have to pay their workers. They pay commissions, and whatever is left over after expenses, their office expenses, that’s their profit. Now, that’s just the simple business of insurance.
When I was down at FinCon a few weeks ago, I spoke with Joshua Sheats, who hosts The Radical Personal Finance Podcasts. Joshua is one of the smartest financial planners I know. He’s got all types of credentials and he is just really, really good when it comes to these technical financial planning concepts.
I said, “Joshua, what do you think about whole life policies, or universal indexed life policies? What’s your view on insurance?” Joshua for many years worked for Northwestern Insurance, a mutual insurance company. His response was you first have to consider safety. In other words, when you buy an insurance policy you want to go with the safest company, which makes sense to me. Ideally a mutual insurance company where the policyholders own the company. He didn’t say just buy term. He said you can use insurance if you think safety first.
Now, there is the potential to earn 4-5% on a whole life policy. The reason why is because what you have to consider is, is the insurance company a better investor than the individual? It depends. It depends on the individual.
A firm like Northwestern Mutual Life, they have a huge investment team and they can invest in asset classes that often time individuals can’t, such as big, private real estate deals, big office buildings that came on the market during the financial crisis, and Northwestern Mutual was able to buy some of those. There are some areas and alternative investments that insurance companies, given their balance sheet, given their superior credit ratings, can take advantage and then pay out policyholders 4-5% on their whole life policies.
That made sense to me. Maybe there is a time where if you think safety first, think low return. This is really a bond replacement. There are individuals that just don’t want to deal with it, and there’s a way to do that.
Now, I got an email recently from Ben, who’s a pilot, and he’s bought a whole life policy. He studied it out, he looked in detail, and it was the right fit for him because he was maxing out his 401k, he was maxing out his IRA, and he was a high income earner, and that’s what he did. If you buy these type of policies you have to go in with the attitude that you’re going to hold it for a long time. This is not a liquid investment.
This is 10, 20 years, and you have got to really, really dig in and understand. I had a board member once on a college that said, “If I don’t understand it and I can’t explain it to a fellow board member, I don’t want to invest in it.” I think insurance very much the same way. You need to understand what you’re buying, and if you don’t understand it, then don’t buy it.
Universal Indexed Life
Now, there’s another insurance policy called universal indexed life, I mentioned. Bridget was the listener that asked me to look at it. I’ve read books on it. I’ve talked to people about it. In this case, this is a policy where you pay … It starts out with the life insurance. All these complex life insurances have a life insurance component.
You have to look at it that way, life insurance first. Second, if it’s complex, you look at it as long-term investment. With whole life they’re promising, so your cash value over time is accumulating, 4-5% a year. With indexed universal life that cash value varies based on what the stock market does. It’s tied to a specific index, and so there’s a floor.
There’s a guaranteed return generally speaking, but then you get the upside in the market up to a certain point, so there’s a cap. You might get any appreciation in the stock market up to, say, 12 or 13%. If the market goes above that, you don’t get that. You don’t get the dividends. You just get this.
How do insurance companies, thinking about a business, accomplish that? They go out into the options market and they buy options on the S&P500, if that’s the index, and so they structure it so they’re buying derivatives and then they’re giving you this upside. I’ve talked to reps that have looked at it in detail, and they’ve torn it apart and they think it’s possible to earn 6-7% a year doing this.
But I was pretty, kind of negative. Well, why would anybody do that when they could just buy term and invest the difference on their own? I remember talking to one individual who’s a financial planner and does deal with indexed universal life, and he says, “Because not everybody can do that. Not everybody wants to invest. They can’t necessarily go out and buy options. They don’t want anything to do with that. For some individuals these complex policies make sense, because they can earn 6-7% over the long term, but they have to keep in mind that they’re keeping it pretty much for the rest of your life.” There are provisions that you can borrow against the policy in your retirement years.
I’m not going to get into the complexities of it, but as I’ve read books about it and I’ve looked at it, I’m still not going to go buy one, because I’d rather buy term and invest the difference. I’m not so naive to say nobody should ever own these types of policies.
What I think individuals should do is only own them if they understand them, spend a great deal of time studying them out, like Ben did, the pilot. I mean he spent hours and hours, as I understand, looking at it, tearing it apart, understanding what the commission is, what are the downside. Recognize that these are not high-earning investments.
Safety first, life insurance first, and then a potential return of 4-5% if you go with a mutual insurance policy, whole life, and maybe 6-7% with indexed universal life. That’s my view on life insurance.
What About Inheritance?
I had one other question on this topic that I got from Glenn. This was a while ago, but he asked how should you treat it if you have an expected inheritance. In other words, you know your parents or relative have wealth and they’ve indicated that it should be coming to you at some point. How should that impact your planning in terms of financial planning in your life?
It’s hard to give a specific answer to that. I don’t know how sure it is, right? My initial answer is don’t plan on it. Maybe you’ll have a falling out. Maybe your parents will live to be 150. That’s being facetious, but perhaps they live. I got an email the other day from somebody whose mom is 104 and is now eating into the principal of her investing.
My view is just don’t assume it’s going to happen, live your life as if it’s not going to happen, and then if it does then you have this unexpected windfall and you can figure out if you should dollar cost average or do a lump sum, and learn, too, the process of psychologically handling these larger sums. Which is why, in summary, I dollar cost average in. I wish I could better answer that, but just don’t plan on it. If it happens, consider it an unexpected windfall.
Everything I’ve shared with you in this episode has been for general education only. I’ve not considered your specific risk profile. I’ve not provided investment advice, simply general education on money, investing, and the economy. Have a great week.