Dealing with a Windfall: Lump Sum or Dollar Cost Averaging

Managing a small, or large, windfall can raise some investing questions. If you invest all of the money according to your overall investment strategy now, will you be buying at precisely the wrong time? The peak of the market like summer 2000 or fall 2007? How do you manage the money while reducing the likelihood of a big loss?

It is important to remember that investing is a game of winning over the long term. However, in shorter time periods, expect that stocks might drop 50% or more. A broad bond fund could drop 20% or more. Real estate has seen drawdowns similar to stocks. Even gold has seen numerous drops of 40% or more.

While everyone wants to buy at the bottom and sell at the top of every cycle for every investment asset, that is clearly impossible. We can only use the historical information we have to try build a portfolio or follow a strategy that generally performs well over time. That's why Leveraged Barbell Portfolios, Dual Momentum, and Trend Following are strategies I can get behind.

When you come into a windfall, which is any amount of significant money for your personal situation, you have two main choices: invest everything now (lump sum), or invest in several chunks spread out over a period of time while holding the remaining amount in cash (dollar cost average). Lets see the best choice for each strategy.

Leveraged Barbell Portfolios

When you choose a Leveraged Barbell Portfolio strategy, the best option for investing a windfall depends on your desired exposure to stocks. That said, I believe most investors should dollar cost average to their desired allocation while ensuring they are 100% invested (I'll explain further down).

It is important to understand in static investment situations (annual re-balancing or similar), you are almost always better off investing in a lump sum. On a monthly basis, stocks go up roughly 60% of all months. On an annual basis, Leveraged Barbell Portfolios are up approximately 80% of all years.

Source: Yahoo Finance

Large drawdowns, which we'll say are 20% or bigger, are actually quite rare. Since 1950, there have been just nine of these larger drawdowns--some short, some longer in duration. Of course, they are all but impossible to predict with any significant degree of accuracy.

Some of the "bad" times to fully invest a windfall in stocks would include 1956, 1961-62, 1968-69, 1972-73, 1981, 1987, 1999-2001, and 2006-08. That means you would have picked the wrong time to invest in just 15 of the past 68 years, or 22% of all years (roughly speaking, of course).

That said, the longest of these drawdowns can take several years to recover from. With re-balancing, a traditional 60% stock & 40% bond portfolio took abour 3 years to recover from the 1973, 2000, and 2008 market events. These are the longest drawdowns in recent history.

However, due to the mechanics of leverage, a comparable 20% 3x leveraged stock and 80% short-term bond portfolio would have hit new highs in just over two years in the 1973 event (50% faster than traditional), in four years in the 2000 crash (14% longer than traditional), and in a bit more than three years in the 2008 event (the same).

Not to downplay the statistical advantages of investing a windfall in a lump sum right away, I believe most investors investing in a Leveraged Barbell Portfolio, are actually better off dollar cost averaging into the stock side for psychological reasons.

Since 1950, a portfolio with 60% exposure to stocks (20% 3x leveraged stocks, or 30% 2x leveraged stocks) would have experienced a maximum peak-to-trough drawdown around 28%. A more aggressive portfolio with 40% 3x leveraged stocks would have seen a drawdown over 52%. These are big hits whose impacts should not be underestimated!

To properly employ dollar cost averaging, start with putting as much money into the stock bucket as you can tolerate. That might mean starting with a 10% or 20% position in 3x leveraged stocks and that's okay. However, don't leave the rest in cold cash, put the remaining money into super safe short-term bonds.

Then, in spacious regular intervals, move another 5 or 10% from bonds to the stock side. Aim to be at your target allocation within two years of your first investment so that you don't "freeze" into an unreasonably low allocation. Remember, peak-to-trough, drawdowns typically last two years or less before turning around aggressively.

I believe it is important to have all your money invested in something at all times to get some returns. This is why I encourage every investor to allocate the money not put into stocks towards short-term bonds. The returns won't be high, but the risks are very low and generally short-term bonds keep pace with inflation. This helps ensure your money won't be losing value to inflation while sitting in cold hard cash.

Dual Momentum

If you are following a Dual Momentum inspired strategy, whether that's the one I share monthly on this blog, the strict Gary Antonacci U.S. version, or another version that is similar in nature, you should always invest your entire windfall in one lump-sum.

The reason for this is that Dual Momentum has a very low historical maximum drawdown. Even if you picked the absolute worst moment to start this strategy in the past 48 years, you would only have experienced a -17.8% drawdown. That is peanuts!

On top of this, 44 of the past 48 years showed positive annual returns. Of those few down years, none of them had double digit annual losses.

Further, more than 70% of all monthly returns were positive. Anytime the odds are that high, you make the bet.

Dual Momentum is such a cautious strategy with factors in place which reduce large, prolonged drawdowns, you should always invest your lump sum into the strategy as soon as you can. You have significant potential that you will be better off than dollar cost averaging within months.

Trend Following Strategies

Trend following is a completely different animal because your exposure to losses can vary significantly. How much you use leverage, what your buy and sell signals are, where you set your stop losses, and the number of markets you track all play a role. Also, trend following means you are embracing both the long and short side of an asset. You cannot be a long-only trend follower.

Trend following is not a specified allocation to certain markets which is re-balanced at regular intervals. Rather, trend following is a unique, comprehensive and systematic investing program which is paired with a rock solid psychological fitness.

For this reason, I don't believe you can dollar cost average into trend following. You have to fully commit to the program you back-tested while making the appropriate adjustments for risk.

When you start trend following with a windfall, begin by investing on the cautious side. Risk no more than a 1% loss (as a percentage of total equity) in any position. Use little to no leverage at the start so you can get a feel for how the markets move. Learn how to identify trends and when to execute buys and sells.

It is especially important to understand whip-saw trades and how emotionally difficult it can be to get kicked out of a position multiple times for small losses. And remember, those small losses can add up! However, it is equally satisfying to see a position move up aggressively with a strong trend as you rake in profits that make up for those small losses.

Let's take a look at some accessible track records from real world professional trend followers.

DUNN Capital, a trend follower with around $1 billion in assets, has seen peak-to-trough drawdowns around -50%. I would say that DUNN is a middle-of-the-road program compared to most professional trend followers as far as aggressiveness, risk management, and leverage go. I should point out that DUNN has been in business since 1984, and has an impressive track record in the past 34 years.

A more aggressive trend following shop, Purple Valley Capital, has seen a max drawdown of around -65%. That's after running their program since the middle of 2008, or a roughly ten year track record. On the flip side, they have also seen annual returns as high as +87.94% in the same period. See Purple Valley's track record.

In contrast, Abraham Trading is a more cautious trend follower that uses little to no leverage. Running since 1988, their program has seen a maximum drawdown of just -32%. They've also managed an annual compounded return over 14% in that time period. See Abraham Trading's track record.

If you want to employ a trend following strategy, all I can say is back-test, back-test, and back-test. Know your system, understand how it works in a wide variety of markets, and be prepared to sit through those tough times.

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