Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: In this week’s Sector Watch, you discussed two investment approaches: dollar cost averaging [DCA] versus lump-sum investing. Can you describe the differences between the two strategies?
Stovall: Dollar cost averaging is when an investor puts an initial amount of money into an investment, and then for a fixed period of time consistently adds more money until the amount desired to be invested has been exhausted. For instance, if an investor has $50,000 to invest, they might decide to put $20,000 in initially, and then put in $1,000 each month or each quarter in the future until the entire $50,000 has been invested. The advantage with this strategy is if I’m worried that the investment might go through a price decline, then I will be buying additional shares at a lower price rather than worrying about whether I am invested at the very peak.
The lump-sum approach says that the investor put all $50,000 to work right away and they’re not going to attempt to time the market. Since the market tends to rise seven out of every 10 years, they believe DCA would simply be putting the money to work at an increasingly higher level than the initial investment.
EQ: So would a dollar cost averaging strategy be more appropriate for conservative investing, and lump sum be categorized as a more aggressive approach?
Stovall: Dollar cost averaging from a behavioral standpoint is more palatable for nervous investors. If they do worry about putting in their money all at once and doing so at the top–such as before Dec. 31, 1999 when the market went through two mega meltdowns or bear markets of 40 percent or more in the coming 10 year period–an investor probably feels better if they put some money to work initially and then put additional money to work over equal increments as well as equal periods of time.
EQ: You took a look at the performance of both approaches since the Dec. 1, 1999 top. How did the two strategies fare against each other?
Stovall: Whenever anybody asks me what’s the right way to do something, my answer is usually, “That depends.” You really can find different approaches that might not agree with what the initial approach could be. For example, if you were investing in the S&P 500 since 1999, you would have been better off using the DCA approach than the lump-sum approach because the market endured two horrendous bear markets and, as a result, investors’ initial investments took that much longer just to get back to break-even. Yet with DCA, an investor was able to start taking advantage of lower prices almost right away.
However, if you look toward the S&P 500 Dividend Aristocrats index–which are companies that have increased their cash payouts to investors in each of the last 25 years—it is traditionally less volatile than the S&P 500, but also pays a much higher dividend yield. What I found was that when it came to the Dividend Aristocrats, it was substantially better to engage in a lump-sum investment approach than it would’ve been to get involve in DCA. The reason is even that though the Dividend Aristocrats did decline in value during the two mega meltdowns, they did not fall nearly as deeply as the S&P 500 itself did, so it took less from a percentage perspective to get back to break-even. In addition, investors can benefit from the power of a compounding dividend yield that is at least 50 percent higher than that of the market as a whole.
EQ: You also broke down the performance of the two approaches by sector. What were you able to find here?
Stovall: Since a lot of investors look to sectors, rather than focusing exclusively on the stock market, I thought it was intriguing to find out if a certain type of sector did better with lump sum and if another type did better with dollar cost averaging. What I found was that the highly cyclical sectors that pay relatively low dividend yields that were crushed early on in this very volatile decade were the ones that did not get back to break-even quickly enough, and therefore were the ones that did better with the DCA than with the lump sum.
The sectors that did best with lump sum are Energy, Consumer Staples and Utilities. These groups are defensive by nature so they tend to lose less when the market declines but they also have relatively high dividend yields, so you’re able to benefit from the power of compound. The three worst performing sectors for lump sum as compared to DCA were Consumer Discretionary, Telecom Services and Information Technology. These were the sectors that were beaten up quite badly in each of the two mega meltdown bear markets.
EQ: Obviously it’s tough to predict which approach will work best going forward, but in what market environment would you lean toward DCA versus lump sum, and vice versa?
Stovall: I would probably lean toward lump sum in most scenarios. If we think that we’re going to remain in this secular or long-term bear market where the S&P 500 will probably not establish an all-time high above the 1565 level that it reached in early October 2007, then we’re probably better off doing lump-sum investing in the defensive sectors such as Consumer Staples, Healthcare, Utilities and Energy. If, however, we find out that we’re actually in the beginning stages of the new secular or long-term bull market, then you probably want to be in those cyclical sectors like Industrials, Technology, and Materials that will benefit from an upwardly climbing stock market. In that scenario, it is better to put the money to work today rather than buying incrementally at increasingly higher prices. So either way, lump sum is probably the best approach. The only outstanding question is whether we are likely continuing in a secular bear market or entering a new bull market. But that’s a question for another time.