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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Dual Momentum: Can I Use An All-World Fund Instead?

I've been wondering about the relative momentum aspect of Gary Antonacci's Dual Momentum strategy for some time now. Does the relative momentum component add a meaningful return to the strategy if you look at the entire world stock market?

To refresh memories, Dual Momentum considers the two main aspects of momentum. Relative momentum is comparing one asset to another asset when both are in the same broader asset class. This can also be called relative strength, or cross-sectional momentum. In the Dual Momentum strategy, we compare U.S. stocks to International-ex U.S. stocks when measuring relative momentum. For those that are curious, U.S. stocks are approximately 80% correlated to International stocks over the past few decades.

The second momentum component is absolute momentum. Absolute momentum is also called time-series momentum. This compares one asset's price now to the price at a prior specified time, such as the performance over the previous twelve months. If the asset has a positive return in excess of the risk-free rate of return (represented by short-term government debt), then the asset it can be said to have positive momentum.

Absolute Momentum Only Studies

Gary Antonacci has done comparisons using absolute momentum himself. But interestingly the only comparisons I can find use a single component: either the absolute momentum of U.S. stocks, or the absolute momentum of International stocks. Both of these types of absolute momentum under-performed Dual Momentum—but that makes sense. Sometimes U.S. stocks do better than International stocks for a period of time and sometimes they don’t. In the long run that means poorer performance if you only use one of these two assets.

What I couldn’t find is an absolute momentum back-test, using Gary Antonacci’s standard twelve month look-back, on Global Stocks as a whole (represented by the MSCI World Index before 1988 and MSCI ACWI All County World Index after 1988).

Since it piqued my curiosity, I decided to do a long back-test—taking things back to 1970. I call it the Global Stocks Absolute Momentum (GSAM) strategy. I had to use 1970 as a start date since I could only find global stock index information going back that far.

For global stocks, I used the MSCI World Index from 1970 through 1988 and I used the MSCI ACWI from 1988 onward. Unlike the MSCI World Index, the MSCI ACWI includes emerging markets as well. Prior to 1988, it's very difficult to obtain good data on emerging markets.

For bonds I had some difficulty locating good monthly data. While the bond rates information is out there, rates on bonds—especially medium term or longer—do not translate easily to monthly performance. So I used U.S. T-bill data from 1970 through 2004 and the ICE 7-10 Year Treasury Index from 2005 onward.

While the bond data issue would have a small effect on returns, it shouldn’t be that significant. If anyone has and can legally share good bond index monthly data that goes back to the 1970s, please let me know and I will tweak my spreadsheets.

My Hypothesis

My idea in doing this study was to test if there was a meaningful advantage in the relative momentum aspect of Dual Momentum when testing the strategy using better stock data.

While U.S. stocks only, or International stocks only, would clearly show a less favorable result, the issue with this comparison is that you only are looking at one-half of the equation. By comparing global stocks as a whole, you are looking at the performance of both U.S. and International stocks in a single package.

As many of the trades in Dual Momentum involve a switch from U.S. stocks to International stocks, and U.S. stocks are quite highly correlated to International stocks, my theory going in was the results of GSAM would be a bit lower performance than Dual Momentum with a lot less trades.

In theory, when U.S. stocks perform better than International stocks, the MSCI World/ACWI indices should go up as a whole somewhere in the middle of the performance of the two asset groups. Likewise when International stocks outperform U.S. stocks. Also, when one stock market group falls, the other tends to follow soon after.

The Results of GSAM

GSAM Logarithmic Scale 1970-2017. Sources: TheRichMoose.com, MSCI Inc., ICE (Interactive Data LLC), FRED (Federal Reserve Bank St. Louis)

After compiling all the information and synthesizing it in a nice spreadsheet, the results are in: eliminating the relative momentum component and comparing only Global Stocks to bonds is not a good idea if you're looking for comparable performance to Dual Momentum.

GSAM tended to do somewhat worse than Gary’s Dual Momentum (GEM) model in nearly all years. In up years, the gains were not quite as high and in down years the drawdowns were a bit worse.

Performance of GSAM vs. Stocks Only

GSAM produced a tidy 10.28% compound annual return from 1970 through 2017. This nicely beat the 8.04% annual return of the MSCI World and MSCI ACWI indices since inception.

The worst year for GSAM was 2011 with a -13.98% result for the year. The best year was 1986 with a 42.81% gain.

This compares to stocks only which would have seen the portfolio fall -43.5% in 2008. The peak to trough decline of stocks by end-of-month data from 2007-09 was -56.22%.

GSAM’s drawdowns were much smaller than investing in stocks only and the out-performance was amazingly consistent over the decades.

The results of GSAM clearly showed out-performance to a global all-stock strategy. $100 invested in January 1970 would have grown to $9,900 on December 2017 following the GSAM strategy. That’s nearly more than double the performance of global stocks only which would have grown to $4,260 in that same time period.

Performance of GSAM vs. Dual Momentum (GEM) Strategy

While Gary Antonacci only has his Dual Momentum performance tracked back to 1974, the results of Dual Momentum are unequivocally better than GSAM. GSAM produced an average annual return of 10.28% compared to Dual Momentum’s 17.5% annual return.

That 7% difference every year adds up significantly over time. Over a typical person’s 35 year timeline of investing, if they save $1,000 a month, that’s the difference between ending up with $3.6 million instead of $20.8 million. Yes… you read that correctly.

As in Dual Momentum, GSAM’s drawdowns were much smaller than investing in stocks only. However, GSAM had somewhat larger drawdowns than Dual Momentum—something that surprised me a little. The drawdown aspect may have something to do with the bond data issue, but I don’t think the difference would be too significant with better data.

One thing the GSAM back-test did show, as suspected, was a lot less trades would have been made. Less than 1 trade per year, on average, was made with the GSAM strategy. That equates to nearly half of the trades made in the Dual Momentum strategy.

While the overall performance was not as good as Dual Momentum, GSAM still has its merits when compared to a simple buy-and-hold Couch Potato strategy. It’s easy to execute, the drawdowns are quite minimal, the strategy is simplistic, and you get decent results.

Unfortunately my hypothesis was only partially correct. If I had to choose between Dual Momentum and GSAM, I would easily choose Dual Momentum. The 7% difference in annual returns is just too high; a 2% or 3% difference might be acceptable if reducing trades was important to you.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing promo links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.