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How to invest cash in a volatile market (or any time, really)

Given that I work with tech professionals, the people who come to me asking for help generally have their financial ducks in a row. They've got a solid handle on cash flow management (and generally aren't interested in keeping up with the Joneses anyway). They're making good use of their employer benefits, putting money into (and often maxing out) their 401(k), and some are even socking money into a Roth IRA via "backdoor" contributions.

So...why come to Seaborn, then? Generally, it's a combination of wanting to optimize even further, use cash flow projections to balance pulling in retirement versus living for today, and make sure their plans don't have any major holes -- they know that they don't know what they don't know.

Sometimes, though, it's quite simple: they're sitting on a lot of cash, and they're not sure what to do with it.

To be clear: they have a lot of good ideas. These are smart people! But they're also tech professionals, subject to analysis paralysis, and because they're not sure, they're hesitant to make a move. So they get a bonus, or their RSU's vest, and they're not sure what the optimal destination for all that money is (and they're not really interested in spending it right now -- see above re: Joneses). So they sit on it, maybe putting some towards their mortgage, while they think about what to do with it. And then another bonus comes in. And their ESPP shares come in. And maybe they're thinking about investing it, but the thought of throwing it all into the market -- especially during, say, a global pandemic -- and risking a sudden drop the day after they invest it...well. It's not a good feeling.

Some of you are thinking, "Man. I wish I had that problem." And that's fine! But if you're thinking, "That sounds kind of like me," then let's walk through a process for figuring out how to optimize that cash -- without taking undue risk!

Step 0: make sure you're in a good place

I'm assuming that if you're in the position I described above, that you've paid off your credit cards, tax liens, or any other high-cost financial liabilities. The interest rate on a credit card dwarfs the expected rate of return of any diversified portfolio, so it rarely makes any sense to go further until you've taken care of that.

Step 1: fund your short-term savings

I'm a huge fan of targeted savings accounts: rather than just having an account labeled "savings", I often recommend having a separate, targeted account for each of your Big Goals. Emergency savings. College savings. Travel savings. New Car savings. Retirement, of course.

Now, will you be able to come up with an exhaustive and immutable list of all your Big Goals? Of course not. But it doesn't have to be! This is part of an adaptive financial plan, a charted course that gets you pointed in the right direction but which you can change on the fly. Decided that you want to travel more, and you're willing to drive an older car for longer in order to get there? Then you can simply move money from one account to another.

So, if you're thinking about investing a bunch of cash, step one is to figure out how much cash not to invest, and put that in targeted savings accounts. (I'm a big fan of online savings at Ally Bank: the interest rates are competitive, it's FDIC-insured, and they make it super easy to create targeted "buckets" within an account!)

By making sure that your short-term goals are held in safe vehicles like online savings accounts, you can invest for your long-term goals with much greater confidence!

(Want to learn more about this step? Head over to the post on Income Allocation.)

Step 2: pay down debt, where appropriate

Student loans, mortgages, and auto loans occupy a "gray area" in financial planning. They're debts, sure, but these days their interest rates are generally much lower than expected returns on a portfolio, so it's often unclear whether it makes more financial sense to pay them down or invest the money.

If you're in this predicament, take a look at this post on prepaying mortgage debt -- the principals apply to just about any reasonable-interest debt. Several things to bear in mind:

  • Investments are volatile, while the ROI on debt payment is fixed and constant.

  • Investments are much more liquid than debt instruments: while it's possible to e.g. tap the equity out of your home, it's much more difficult than getting money out of an investment account.

  • Assuming it's something you could knock out relatively quickly, consider the effect of paying off a debt on your cash flow. If your monthly cash flow is tight, this may give you some much needed breathing room.

And don't forget your emotions! If you're particularly anxious about holding debt -- or would feel particularly satisfied by paying it off -- then make room for that in your equations. We're engineers, but we're still human.

Step 3: determine your asset allocation & implementation

Alright, so now we're at the point where we've got cash that's primed for long-term investing. Next up: when we do invest, what exactly are we going to invest in? This is where you determine your risk tolerance and risk capacity. Whatever your equity allocation is, be prepared to lose half of it in a large downturn; in other words, if you decide on a 50% stock/50% bond split, think about how you'd feel if your portfolio dropped by 25%. (Financial planners have been saying this as long as I can remember, and this is exactly what happened to just about all portfolios in 2008.)

As for the details: don't get wrapped around the axle trying to figure out how much to put in US v. international stocks, or large-cap versus small-cap, or whether to use Vanguard or Schwab or ETF's or mutual funds. If this is your point of analysis paralysis, then just pick something diversified that fits your risk tolerance and capacity and move on; you can come back and optimize later! There are plenty of solid prebuilt portfolios out there, like Betterment's "robo-advisor" solution or Vanguard's LifeStrategy funds; all you need to know is your risk tolerance and capacity, and they'll take care of the rest.

Are they 100% optimized for your situation? Probably not. But the expected return is definitely higher than your savings interest rate!

Step 4: invest!

You've got $100K sitting in cash, and you've figured out how to invest it. Now's the part where I tell you to wake up one day and invest it all, right?

Not necessarily.

There are several strategies out there for investing cash. The simplest is the one I just described, called "lump-sum investing". Another popular one is "dollar-cost averaging" (DCA), which is just a fancy way of saying "invest the same amount of cash periodically over time". (For example: investing $12,000 by investing $1000 each month for 12 months.) You can also get fancy by considering value averaging, but I'm going to ignore it for purposes of this post, because (per the references in the link above) it's extremely unclear as to whether it actually provides value.

So let's look at the data on dollar-cost averaging versus lump-sum investing, shall we? Of Dollars And Data has some great analysis on this. I highly recommend reading the article all the way through; he's a good writer, and he's got nice graphs that make things clear!

The top-level highlight is this: in the years from 1960-2018 (the years for which he had good data), for the standard-issue 60/40 portfolio studied, lump sum investing outperformed 12-month dollar-cost averaging 80% of the time.

This shouldn't be surprising; after all, the market goes up more than it goes down, or we wouldn't invest in it, would we? And while 80% is big, it's not 100% -- there are definitely times when DCA would have outperformed, such as the 12 months of fun before March 2009.

If you're talking about your periodic bonuses or RSU's or ESPP, you could stop there; investing it all at once will likely be the optimal path, and because we're talking about periodic income, you can likely afford to take the occasional loss.

But if we're talking about cash that's accumulated over years, we might want to dig deeper. Unlike investing periodic income, we're talking about a single large bet, not a bunch of small ones -- a 20% chance of underperformance is not 0%!

So let's take a look at the average underperformance of 12-month DCA: according to his data, how much money are we leaving on the table that year, on average? The answer: 3.7%. Note that this is percent, not basis points; it's the difference between e.g. 10% and 9.63% ROI for the year.

Speaking as a financial advisor, I'm generally not going to fall on my sword over a single year of 3.7% underperformance. Don't get me wrong -- with $100,000 on the table, it's not nothing. But for most of my clients, it's worth it to be able to sleep at night!

Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.

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