Is now a good time to invest in the stock market? I’m asked this question more often these days. The market has steadily increased in value over the last several years. Will it continue? What should I do?
Start by reviewing your plan. Because your plan reflects your circumstances and goals, if they change, it could mean changes to your plan. Does your plan still align with your long-term goals? Has anything changed to affect your tolerance for risk, for example, a change in income, job security or health? Have you re-balanced your investments at least annually to return to your original plan allocation? If you’re comfortable with your plan and you have a 20+ year investment horizon, general advice is to stay the course.
But what if you have a lump sum to invest? Today’s market valuation has people thinking twice before investing a large amount. There’s an alternative strategy – dollar-cost averaging. For example, instead of adding $10,000 to your plan, consider spreading your investment over five months, $2000 at a time. If the market drops, your monthly investment will buy more shares; if it increases, your monthly investment will buy fewer shares. This reduces the temptation to try to time the market – we think a fool’s game.
In reality, most of us are already spreading the risk of investing by dollar-cost averaging into our employer’s retirement plan. But what about funding your Roth IRA? Should you fully fund it at the beginning of the year or on a monthly basis? We know that lump-sum investing gives your investments exposure to the markets sooner.
What do the numbers say? Andy Clarke, a senior investment strategist in Vanguard Investment Strategy Group, addressed this question in his blog titled “Investing Fast and Slow”. He compares it to jumping versus wading into cold water. The conclusion? In two-thirds of the instances studied, investing a lump sum (jumping in rather than wading) yielded higher returns! This is supported by Vanguard’s white paper Dollar-cost Averaging Just Means Taking Risk Later.
What’s the right choice for you? The answer depends on your behavior as an investor: your tolerance for risk, your investing horizon and your confidence in your plan. In other words, how would you react if your investment dropped significantly on Day 2? You’re the best judge of that.