Got a Big Lump Sum to Invest? Watch Out for Vintage Risk

An occupational hazard of working in a profession like investing is that you often find yourself analyzing everyday life situations as if they were investments. I experienced this when my wife and I visited Napa Valley this fall and had the opportunity to taste several extraordinary wines — wines normally well beyond our price range. During our visit, I decided to conduct a mini-survey of the various vineyards we visited. My question: Is the quality of a wine pre-determined by the quality of a grape, or is the winemaking process most responsible for creating an exceptional wine?

My very scientific study resulted in a consensus: Winemakers say the quality of the grape dictates the potential quality of the wine, and the winemaking process only serves to help that grape realize its potential. So, while the process certainly matters, you can only get so good if you start with an average vintage of grape.

How Vintage Risk Bubbles Up over Time

Just as with growing grapes, good years and bad years are also an intrinsic part of economies and markets. Certain “vintages,” like 2019, are banner years for the equity markets generally. In 2019, even with flat earnings, the S&P 500 experienced 30% gains. Any portfolio weighted toward U.S. equities in 2019 likely had a very good year. On the other hand, in years like 2011, 2015 and 2018, the broader market produced less spectacular returns. As a result, portfolios weighted to U.S. equities in those years likely produced similarly unspectacular results.

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To mitigate the risk of any particular cycle, investors are advised to take a long-term view, to diversify their investments across various asset classes and strategies, and to not base the timing of their investment decisions based on predictions of future market cycles. However, in certain situations implementing this advice is easier said than done.

In my field of private equity investing, fund managers are judged based on the performance of their fund vintage. But what exactly is meant by “vintage” in the context of investing — a concept more familiar to wine enthusiasts than to investors? Put simply, when investing large sums in a small number of companies, you are inherently taking a market timing risk, because you must buy the whole company all at once instead of investing a little bit each month over time. In doing so, you run the risk that valuations for deals made in a particular fund year, or vintage, were particularly high due to a frothy M&A market or an impending recession. Even the best fund managers had trouble producing spectacular returns from funds raised just before the Great Recession. In other words, just like with growing grapes, sometimes private equity fund returns are driven more by the year the fund was raised than by the quality of the investing process used to deploy that fund.

To separate the good fund managers from the bad, it’s therefore important to know which ones benefited more from a general rising tide than from investing skills and business acumen. As such, sophisticated institutional investors evaluate the private equity funds to which they allocate their investment dollars, not only do they consider a fund manager’s absolute performance history, but they also evaluate that performance history in the context of a fund’s vintage.

Vintage Risk Is Especially Worrisome When a Windfall Blows Your Way

So how does this wine and private equity analogy apply to the average investor? When saving for retirement, financial planners often advise following principles like paying yourself first each month and dollar-cost-averaging to limit the impact of marketing timing. This is great advice when your financial situation is in a relatively steady state. However, there’s one scenario where this approach should be modified: when an investor is seeking to invest a large, one-time cash windfall. In this case, investors must also factor vintage risk into their decision-making.

There are many scenarios where an investor might receive a one-time, lump sum cash windfall. For instance, my firm recently invested in a wonderful family business. We were proud that our investment supported the succession planning goals of the two owners who were nearing retirement age and whose children didn’t work in the business. Our investment resulted in a one-time windfall for the owners.

One question they had for us — which also applies to anyone who sold a business, received a substantial inheritance or retirement package, sold property or any of the many other ways one might come into a large amount of money — was what to do with their newfound cash. Our answer: Diversify across asset classes based on your goals and risk tolerance, but also to invest it slowly over time to avoid vintage risk!

Invest that Windfall Slowly But Surely

Many experienced investors work with a trusted financial adviser, and most advisers will always have their clients’ best interests at heart. However, there’s an inherent potential risk in the adviser model if a financial adviser is paid based on a percentage of invested assets under management. If a client keeps a lot of money in cash instead of investing it in the market all at once, they risk creating a misalignment of incentives between their desire to manage vintage risk and their adviser’s desire to maximize assets under management.

Yet the best way to manage vintage risk when investing a windfall is to do just this! Therefore, once you and your adviser have determined your desired allocation strategy, it’s important to proactively insist on deploying any one-time cash windfall slowly and methodically over time — thereby limiting the impact of any specific market timing.

After the strong stock market returns of 2019, it’s timely to remind investors about vintage risk — especially when investing large sums of cash at one time. By investing that cash over time, investors can diversify the risk of market timing in a way that other diversification and rebalancing strategies aren’t able to do. And for investors wary of leaving money on the table by keeping it in cash, remember what Warren Buffett has said about the value of cash: Its value isn’t simply the returns it generates but also the optionality it provides for investors who want to take advantage of opportunities.

Hopefully 2020 is another great vintage for the market (and for wine). If you find yourself in the fortunate position of receiving a large financial windfall, it’s good to remember Buffett’s advice and also to remember to consider vintage risk.