Does your organization have excess cash above what it needs for operations? When a nonprofit organization makes the decision to do more with their cash and opens a new investment account, finance committees often ask: Should cash be invested in the stock market all at once or over a period of time? This question is particularly relevant in an environment when the market has been up sharply and stock prices are relatively high.
Many organizations choose to invest their cash gradually. This strategy is frequently called dollar cost averaging. With this approach, instead of a single purchase at one price, you invest in stocks at regular intervals over a period of time. This reduces the risk of paying too much for an investment right before the market drops.
1. Takes advantage of a volatile market
Over the long term, stock prices tend to rise. However, short-term price swings in the stock market can be extreme. Such severe volatility was a reality in 2020 when nearly 25% of all trading days resulted in price swings of 3% or more for the S&P 500. Dollar cost averaging allows investors to take advantage of such volatility by spreading out stock purchases and diversifying the prices paid for investments.
Let’s say your organization invests $1,000,000 in stocks (based on a prudently developed asset allocation plan - see our paper “3 Key Factors of an Optimal Asset Allocation Policy”). Here’s what a simple dollar cost averaging approach might look like based on actual data in 2020 (using the SPY which is an S&P 500 Index Fund, as a proxy for the equity market):
Average Price per Share: $294.99
If you had invested the entire $1,000,000 on January 21, you would have purchased 3,018 shares at $331.30. But by investing over the course of five months, you were able to buy 3,454 shares for an average price of $294.99. So, dollar cost averaging resulted in your account owning 14% more shares to benefit from long term appreciation!
2. Easier to initiate and stick with an investment program
Market volatility was more significant in 2020 than most years, but in such extraordinary periods, an initial lump sum investment could have experienced a relatively sharp loss (or gain). Rather than investing all of your organization’s cash on potentially the ‘wrong day’, dollar cost averaging can help investors avoid potential short term losses by smoothing out their purchases.
Academic research1 on investor psychology makes clear that people often second guess their investment decisions or get too emotional as market conditions change. Investing a fixed amount at predetermined intervals can help investment committees agree to implement and stick to a sound plan.
3. Establishes a solid basis for investing ongoing cash contributions
Employing a strategy of putting cash into the stock market in intervals sets an organization up well for adopting an ongoing cash investment program. A committee may agree that as cash builds to a certain level, it should be invested and the portion allocated to stocks makes a purchase at yet another interval. This strategy can help ensure that committees aren’t holding cash instead of investing when members may be nervous about market conditions.
Dollar cost averaging does not always result in a better outcome than making an initial lump sum investment. Research2 shows that over the very long term, lump sum investing may outperform dollar cost averaging. That’s because the stock market tends to go up more than it goes down. But investing in extreme market conditions can be stressful for an investment committee. Dollar cost averaging helps many committees take the emotion out of purchasing decisions and is often successful at reducing risk during market environments with extreme volatility.
Consider if dollar cost averaging could help your committee establish a sound investment program that positions your organization for success for years to come.
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1 Kahneman, Daniel. Thinking, Fast and Slow, Farrar, Straus and Giroux, 2011.
2 Shtekhman, Anatoly, Tasopoulos, Christos, & Wimmer, Brian (2012). Dollar-Cost Averaging
Just Means Taking Risk Later. The Vanguard Group.
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