A few weeks back, I talked about the good-is-better-than-perfect principle. A close corollary is to approach financial decisions incrementally. What do I mean by that? An example is dollar cost averaging, whereby a sum of money is invested in regular increments rather than all at once.
Does dollar cost averaging guarantee a better outcome? No. But a key benefit is that it takes what would be one big decision and breaks it down into several smaller ones. The benefit: Each of those smaller decisions ends up carrying lower stakes. And just as importantly, when a decision is broken down like this, there’s more room for flexibility—for iterating and for adjusting to new information.
Here are several other situations in which you might consider making decisions incrementally:
Asset allocation – Suppose you’ve decided to change your asset allocation. You could do it all at once. Sometimes that’s advisable. But in many cases, it makes sense to move incrementally, for this reason: It’s often hard to know how you’ll like something until you’ve tried it. Think about it like adjusting the heat in your home. You might start by turning the thermostat to 70. But when it gets there, you might decide it’s still a little cool. Then you’d bump it up another few degrees. It’s the same with your investments. It’s very hard to know how a particular portfolio will feel, especially from a risk perspective, until you’ve tried it and lived with it for a while. To be sure, you don’t want to make adjustments every day. But if you’re considering a big move, it might make sense to take it one step at a time.
Rebalancing – Last year, as I’m sure you recall, the stock market dropped sharply in the early days of the pandemic. It was a great opportunity to rebalance and buy stocks at a discount. But it wasn’t easy. After hitting a peak on February 19th, the market declined 8% over the following week. That might have looked like a good buying opportunity, especially because the market staged a little bit of a recovery over the subsequent week. But a week after that, it was down 19%. And a week after that, 29%. Ultimately, it hit bottom 34% below its prior peak on March 23rd. With the benefit of hindsight, that would have been the perfect date on which to rebalance. But no one could have known that while we were in the middle of it. That’s why I think rebalancing is best done incrementally. You’ll never get it perfectly right, but you might get it more right than if you tried to pick one date and do it all at once.
529 contributions – How much should you contribute to a 529 account for your children or grandchildren? The answer: It depends. Think of all the unknowns: where they’ll go to school, whether they’ll go to graduate school, the rate of tuition increases at those schools, whether they’ll earn scholarships and, of course, how fast your investments grow. For all those reasons, unless the market is really depressed, I generally don’t recommend taking advantage of the five-year frontloading provision in the 529 rules. Instead, I think it’s best to take it year by year. That gives you the opportunity to adjust your contributions over time, as each of the unknowns comes into better focus.
New investments – For better or worse, investment markets always deliver something new to worry about. This year it’s inflation. A few years ago, it was rising interest rates. A few years before that, it was dollar appreciation. In response to each of these worries, the mutual fund industry happily devises a new strategy. The problem, though, is that nothing is permanent. Sometimes these worries fade, and sometimes they even reverse. So you wouldn’t want to reformulate your portfolio in response to every piece of news. At the same time, the world does change, so you can’t ignore every new development. That’s why I’d take an incremental approach in making big changes to your portfolio.
Roth conversions – Roth conversions can be a terrific strategy. And while it makes sense to map out a multi-year plan for conversions, the reality is that you’ll still need to take it year by year. Why’s that? The key to successful Roth conversions is to keep your taxable income below a targeted tax bracket. As a result, you’ll want to revisit the calculation each year—usually around this time of year, when you have a good sense of your other income. Another reason to take it incrementally: As we’re witnessing in real time, Congress can change the tax brackets at any time, upending previous calculations.
Concentrated positions – If you have a big position in a single stock, you may be wondering what the right strategy is. You could hold onto it, but that carries risk if the company runs into trouble. On the other hand, you could sell it, but that could carry tax consequences. It could also lead to regret, if the stock continues to rise. Of course, you could donate it, but that only makes sense if you don’t need the money. The solution: I recommend making a long-term sale plan—like a dollar cost averaging program, but in reverse. Suppose you have 10,000 shares of something. You could sell 1,000 shares every year for ten years. Will it be perfectly optimal? Of course not, but I see this as a reasonable way to balance all the risks.
Gifting – If your portfolio has seen big gains in recent years, you might be thinking about gifting to the next generation. But at the same time, you might worry about the impact. It can be a problem if children receive too big a windfall too quickly. That’s why I recommend an incremental approach. If you start with small gifts, any mistakes children make with these funds will be low stakes. That will give them an opportunity to learn before you increase the amounts.
Loans – If you’re in a position to pay off a significant loan, such as a mortgage or student loan, should you? The way I look at it, paying off a loan involves a trade-off: Pay it off, and you’ll lower your monthly cash needs. But you’ll also reduce your cash reserves. On the other hand, if you keep the loan, your cash reserves will be higher, but so will your monthly cash needs. If you had perfect information about your future income and expenses, this might be an easy decision. In the absence of that, this is another area where you might take it one step at a time. There’s no need to view it as an all-or-nothing decision.