March 17, 2020

The Objective of the Analysis

Over the past few years, some investors have remained on the sidelines with significant cash balances. The prospect of entering the market can swing between concern with bad timing when the equity market is hitting all-time highs or paralysis when the market is falling.  As stated in our recent piece, “Navigating a Changing Narrative”, one consideration given current conditions is to capitalize on market volatility. For cash on the sidelines, current conditions might provide a favorable opportunity to begin an investment program that both takes place over time and is proactive in the face of market selloffs. Like all long-term investors, we believe everything should be done in relation to a strategic plan. For those individuals looking to deploy cash, instead of relying on a few anecdotal examples or personal experiences, we looked at the long-term historical data to see how different options for cash deployment would have performed.

Our analysis below will show that Dollar Cost Averaging (“DCA”; i.e., investing evenly over a certain time frame) with some initial entries and accelerated investments during down months can reduce risk significantly while still capturing most of the gains.  Our analysis also shows that different cash deployment options have different risk and return dynamics, and the ultimate decision depends on the risk tolerance of an investor.

Historical Backtesting

We used 25 years of data (January 1993 to December 2018) for our analysis, and we calculated rolling 12-month returns for the different scenarios described below. The options 1 through 3d are below. 

1) Invest everything in one lump sum at the beginning;

2) Invest evenly over 12 months; or

3) Invest an “initial entry” amount at the beginning and the rest in equal proportions.  Then, for each month in which the equity market is down 5% or greater, accelerate an additional half-month allocation (and if the equity market is down by 10%, accelerate a full month, etc.).

Below are the four scenarios for the initial entry used in our analysis: 

a) 0% now;

b) 20% now;

c) 30% now; or

d) 40% now

In order to imitate a portfolio for an investor of average risk tolerance, the money was invested in a portfolio of 60% stock (S&P 500 Index) and 40% bond (Barclays Aggregate Bond Index).  For the cash proportion that awaits investment, we assume a risk-free T-Bill rate of return (Barclays 1-3month Treasury Bill Index). 

To illustrate how 12-month returns for the different scenarios were calculated, we will use an example of $100 cash at the beginning of January 1993.  In this example, a 12-month return is the value of the portfolio at the end of December 1993 divided by the initial cash (+$100) and minus 1. 

The $100 cash in the example would be invested for the different scenarios in the following ways:

1) Invest all (+$100) in the balanced portfolio (60% stock and 40% bond) at the beginning of January 1993.

2) Invest evenly (+$10) each month over 12 months, from the beginning of January 1993 to the beginning of December 1993, in the balanced portfolio. 

3) Invest an “intial entry” amount ($0, $20, $30, or $40) in the balanced portfolio at the beginning of January 1993, and the rest in equal proportions ($100/12, $80/12, $70/12, or $60/12) every month from the beginning of January 1993 to the beginning of December 1993 or until the money runs out.  If the equity market is down 5% or greater, invest an additional half-month allocation ($100/24, $80/24, $70/24, or $60/24).   

Table 1 shows average 12-month returns, standard deviations of the 12-month returns, and Sharpe ratios1 for the different cash deployment options described above, based on the 25 years of data. 

 

As expected, investing all at once (at the beginning) had the highest average return, but with the highest risk (standard deviation). This option, however, also had the lowest Sharpe ratio, or return per unit of risk. Investing evenly had the lowest return and but also the lowest risk. While the Sharpe ratio was the highest of the options, it only captured 2/3 of the average return of the lump sum approach.  Blended approaches, with some initial entries (20%, 30%, or 40% now) and DCA with accelerated investments during down months, had return and risk rewards in-between the first two options. For example, the blended approach with a 40% initial entry (option “3d”) captured more than 80% of the average return of the lump sum approach while being subjected to less than 75% of the volatility of returns that the lump sum approach would have experienced over this timeframe.   

In addition to the statistics in Table 1, we also looked at the histograms of 12-month returns for the different scenarios.  Investing everything in one lump sum had more extreme outcomes than the blend approaches (see Figure 1), with both the downside tail and upside tail increasing in likelihood.

Takeaways

Given the results of our analysis, all five scenarios (excluding the blended approach with 0% initial entry) can be good cash deployment options, providing different return and risk profiles. Analyzing the historical 12-month returns for the different cash deployment options helps to understand return and risk dynamics for these options. 

Investing all at once may have the highest expected return on average, but it comes with the highest risk and lowest Sharpe ratio. It is likely to be a good option only for investors with a very high-risk appetite. For an investor with low risk tolerance, investing evenly over 12 months can be a good option – it forgoes expected gains (on average) but reduces the volatility of the potential returns very significantly.  For an investor who wants reduced risk while capturing most of the upside, a blended approach with an initial entry amount and then a DCA program combined with accelerated investments during down months can provide an attractive return and risk/reward tradeoff. These blended options capture a large proportion of the upside and still reduce the risk of an ill-timed entry into the market.

 

 

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