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IF THERE’S MONEY you’ll need to spend in the next 12 months, you don’t want to put it at risk, so savings accounts, money market funds and similar cash investments are the only prudent choice. But as your time horizon lengthens, holding cash becomes less and less appealing. The reason: Your money’s purchasing power is pretty much guaranteed to shrink, once inflation and taxes take their toll.
Got cash in your long-term investment portfolio? You should move it into something that offers a higher return. For instance, shifting from Vanguard’s prime money market fund to its short-term corporate bond index fund would give you an extra 1.4 percentage points in annual yield. The danger: If interest rates climbed one percentage point, the short-term bond fund would suffer a 2.8% price drop—a loss you would eventually recoup through the higher yield, but it would take two years.
Of course, if you’re a truly long-term investor, you would probably want to opt for something with the prospect of even higher returns—meaning stocks. Suddenly, the potential short-term loss is a whole lot larger, as we know from the S&P 500’s 49% price drop during the 2000-02 bear market and its 57% swoon in 2007-09.
That possibility is enough to paralyze many investors. How can you unfreeze yourself? Start by deciding what percentage of your portfolio you want in stocks. How can you get from here to your target stock allocation? History tells us that you’ll clock the highest return by moving everything into stocks right away. This is no great surprise: The broad market rises over time, so buying sooner will, on average, give you a better result.
Problem is, you won’t get an average result. Instead, you get just one shot at moving all that cash into stocks, and buying all at once risks buying just before a major crash. The older you are and the bigger the sum involved, the more cautious you’ll want to be.
My suggested strategy—which regular readers have heard before: Take the money you want to move into stocks and divide it into 24 or 36 chunks. Move one chunk into stocks every month, with the goal of being fully invested within two or three years. If share prices drop 15% from current levels, double your monthly purchases. If the market falls 25%, triple your purchases.
What if you settle on a target stock allocation—and discover you currently have too much in stocks? While I favor the low-risk strategy of buying stocks slowly, I advocate selling quickly.
Many folks, of course, do just the opposite: If they discover they have too much in stocks, they will often slowly ease out of the market. This is all about aversion to regret: They hate the idea that they’ll sell a big chunk of stock and the market promptly rockets higher. But remember, while buying stocks slowly reduces risk, selling slowly increases it—because you stay over-weighted in stocks for longer and the market could go against you.
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