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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Forget About Good Deals

There a few investors who can buy stocks, or other financial assets, on sale and succeed over the long haul. The winners are household names, the value kings. Warren Buffett and Charlie Munger, Joel Greenblatt, Seth Klarman, David Tepper, and maybe a few others.

Interestingly, many of these famous value investors have actually strayed a bit from their true value roots. Buffett and Munger are now better described as "quality" investors, choosing factors like growing free cash flow, low debt, and profitability over price. This has evolved into the famous line "great companies at fair prices".

On the other hand, Klarman and Tepper run hedge funds using a lot of derivatives and leverage and are noted for being contrarians--a very different strategy from value investing as most amateur investors know it.

Value Investing

While it's certainly extremely difficult, I'm not suggesting that it is impossible to be a profitable value investor. There are clearly people out there who do well in value investing, scouring the markets for deals based on factors like Price/Book, Price/Earnings, Price/Free Cash Flow, and Enterprise Value/EBIT ratios.

The challenge is that you, the amateur investor, must be firmly rational in all your investment decisions in a systematic manner. At the same time, you must believe the entire market is irrational in its pricing of those same investment positions. That takes cojones.

Aside from the contrarian nature of value investing, there is also a massive built-in problem: the "Value Trap". A stock that is falling in price can look like a better and better buy based on value metrics right up to the point where it's essentially worthless. To protect yourself, a successful value investor needs to know exactly when to buy, how much to buy, and, maybe more importantly, when to cut your losses.

Broad-based value investing, in the form of buying the lower valued chunks of broad markets, seems to be failing in many ways. Over the past ten years, traditional, passive value funds have under-performed the whole U.S. stock market by more than 1.3% per year. Over that ten years, that translates to a cumulative investment growth of 136% versus just 106% for value. It's too soon to say if passive value is dead, or if its a temporary blip, or anything else in particular.

Every strategy has periods of out-performance and under-performance, but the widely believed value premium is certainly not a given. Even Jack Bogle, a noted proponent of passive investing, has suggested that historical analysis demonstrating a value premium is flawed. The suggestion is the value premium is actually a case of cherry-picking a good time for value investing, but over long time periods passive value will perform equal to or less than the broad market.

Trend Investing

This is why I choose trend investing instead, using leverage and a range of markets. Although buying something that appears to be on sale appeals to the frugality in me, I would rather buy something that is going up in price. I am content to following the collective rational and irrational players in the markets who slog it out every day determining the price of everything.

If the participants of a liquid market are bidding the price of a particular stock higher and higher, there's something going on under the surface. A company might be producing highly profitable products that are selling faster and faster, a company may have cut costs to increase profitability, maybe there's a takeover coming that hasn't been announced yet.

If the market is bidding down a currency, maybe the country is in economic trouble. Perhaps interest rates in the country are too high and the market is betting that rates will fall. Maybe the country is intentionally devaluing to try boost exports as part of their economic policy.

The same logic applies to interest rates. Interest rates are a great measure of risk and perceived risk. In general, the more financially responsible a borrower is, the better their rates will be. If national debt rates are going down, chances are the country is doing well, the government is going down a more fiscally responsible path, there might be a positive trade balance meaning foreign currency is pouring into the local economy.

On the other hand, if interest rates are going up, lets say on corporate debt, it might be a good signal to sell. Rates on corporate debt often begin to rise when the markets believe a company is getting into some kind of trouble. Maybe they have too much debt on their books, it could be an issue of declining market prospects in that company's sector, sometimes sales and profitability are an issue. Other times the market believes the assets held by the corporation might not be worth as much as the company has stated in the past.

It is difficult and maybe even impossible to decipher the exact reasons why price is going one way or another. However, it's easy to decipher the price itself. The price is published every day, every hour, every minute, every second and it tends to trend.

Where Valuation Comes Into Play

Just because I invest based on the market price and the trends in those prices doesn't mean I believe the price is correct relative to fundamentals. More often than not, I ignore fundamentals. To me, fundamentals and valuation come a distant second to the trend of the price alone.

No matter how cheap an asset is, I will not buy it because it is cheap. The asset only comes into consideration if the price is moving up and has entered an up-trend. I understand that means I don't buy at the cheapest price possible, but that's precisely my goal.

I would rather have the market as a whole identify a bottom and turn around a price than try finding that bottom myself only to miss over and over.

For me, cheapness, or valuation, are only important when cash is limited and I have to decide between two or more investments that are in a price up-trend. In this situation, I will go with the cheaper asset provided other factors are more or less equal.

For example, lets say I have 10% of my portfolio in cash that can be allocated to investments. There are two markets that I am following which have recently entered an uptrend. I can only buy one of those two assets, which one should I choose? Well, this is where valuation comes into play. If Market A is in the 99th percentile of its historical valuation and Market B is at the 60th percentile of its historical valuation, I will choose Market B.

Sure, Market A might go completely crazy and hit the moon. But a reasonable person making disciplined bets would have to agree that Market B has more room to run before the price gets into unprecedented territory. On a balance of probabilities, Market B is the better market to invest in.

Always buy into an up-trend and ignore value unless resources are limited while opportunities are plentiful.

Comments & Questions

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