Investing a lump sum vs pound-cost averaging
Updated
August 28, 2024
Which of the two is the better investment strategy?
As investors, we're subject to the ups and downs of the market. It's the price we pay in hopes of generating long-term wealth from the hopeful outperformance of shares over cash. But, alongside the task of identifying the best stocks to buy, is the thorny question of ‘when is the best time to invest in the stock market?'
Should you save up cash with the intention of investing a lump sum or is it better to have a regular investment strategy, maybe making investments monthly, ticking over instead?
Well that's what we're all here to find out. So, strap in and get ready to get to grips with:
As with most aspects of investing, there's the mathematical side to investing a lump sum and then there's how it fits into real life.
Realistically, even if the maths checks out one way or another, we need to factor in when we can actually invest, how long for, how much we have, what we want from it all and whether our risk tolerance can get us there.
Regular investing also doesn't have to mean a monthly investment plan. But a lot of people find they tend to look at most expenditures through the lens of their monthly salary.
So, investing just after you get paid can make budgeting easier and, in a world filled with monthly subscriptions, you can make investments monthly in exactly the same way.
You're probably already investing monthly through your workplace pension anyway so doing the same with your stocks and shares ISA, self-invested personal pension (SIPP) or general investment account (GIA) could feel like a good fit too.
What if you've already got a chunk of cash sitting and ready to be invested though? That can often be the case if you receive an inheritance or get a bonus at work.
In that case, the question of whether to drip feed your money into your investments or invest a lump sum all at once becomes a bit more nuanced, as the salary parallel doesn't quite fit.
This is where the practicalities of life give way to more market-centric considerations. So what does conventional market wisdom tell us is the best way to invest a lump sum?
Let's have a look at a few approaches and how successful they've been in the past. As always though, past or historical performance is just a view of what's already happened. It's not a definitive guide to what future performance could entail.
We kicked off with the idea of investing regularly, so let's look at that and specifically the concept of pound cost averaging.
Pound-cost averaging, synonymous with dollar-cost averaging, is a strategy investors often use to smooth out the ups and downs of the market. It involves making regular investments which naturally catch market highs and lows and everywhere in between. The goal is to end up with an average purchase price which should look a lot smoother throughout the life of the investment.
Theory is great, but let's have a look at pound-cost averaging in action.
Let's say we want to invest £200 each month into an imaginary stock. The first time we buy it we can pick up 20 shares for £10 a pop. Given we'd be buying full shares each month, that £200 will buy more shares when the stock price is low and fewer if the stock price rises.
The result in our hypothetical example is that, after a year of wavering share prices, we've spent £2,394 on 245 shares.
For the same 245 shares at the outset, we'd have paid £2,450, so simply drip feeding our money into the market at monthly intervals would have fared better.
Now, we can't go any further without pointing out it could absolutely have gone the other way.
If the shares had instead climbed on a consistent basis over the year, you would definitely have been better off buying them all at once initially.
And there could have been a dividend on offer at some stage during the year which would have benefited from an initial lump sum investment too.
The key part here is that we just don't know how the market or a specific stock will look in a given period of time. So, as we've said, there's a psychological benefit to investing regularly and knowing all of your money isn't exposed to any potential drops.
This is really where pound-cost averaging can shine. If a stock declines and we continue to pick up shares, we can reduce the average market price we pay over the long term. Had we been fully invested, our whole stake is subject to those market ups and downs.
In this sense, pound-cost averaging can help us sleep better at night. We know that, even if the market falls, we'll be able to buy more of the shares at lower asset prices.
Obviously we don't want that to continue for too long, but it helps mitigate against one fall taking our entire holding down.
In short, pound-cost averaging is about:
Lump sum investing puts your money to work straight away. Given we know that the time you give your money to grow is an incredibly important aspect to long-term investing, putting that lump sum into the market right away rather than spacing out regular investments certainly hits the time brief.
Lump sum investing can make sense where an investment platform has high trading fees too. If you have to pay £10 every time you buy a stock, investment trust or exchange-traded fund (ETF) that would already set you back £120 a year on a monthly investing plan. So, it's probably more reasonable for investors to save up two or three months' worth of earmarked money and invest that less frequently.
It would be disappointing to let the platform dictate your strategy though, especially if it leads to an erratic investment schedule just because of pricing outside your control.
That's much less of a consideration when those trading costs are low or the platform is commission-free.
There's a behavioural niggle that can crop up if you're storing up a few months' worth of cash though, and that's the urge to want to time the market.
Whether you're sitting with a lump sum from an inheritance, bonus or just general under-the-bed saving that you'd like to invest, there is always the temptation to hold off for a slightly better price tomorrow.
It's natural to want the best price but the evidence shows us it's better to focus on the time you give your investments rather than that very first price you buy in at.
Take five very different investors, for example.
Each of them received $2,000 at the beginning of every year from 2001-2020.
So, who fared best?
Past performance is not a reliable indicator of future returns.
Source: FE, as at 17 Aug 2022. Basis: bid-bid in local currency terms with income reinvested.
A few key takeaways here, with the obligatory reminder that none of this dictates what might happen in the future in terms of investment returns.
Perfect timing won, but the main point is just how difficult that would have been in the real world. You can have all the investing skill in the world but getting these calls right consistently comes down to sheer luck, and you can't bank on that.
You could just as easily have been the bad timer. Or the side line waiter if you had figured a better opportunity was always just about to arrive.
We need to go back to what we said at the start. The maths might tell us which approach gave the best returns but there is just no accounting for real circumstances.
If we discount our ability to time the market perfectly, in the end having your money in the market is the most important thing.
The immediate investor has the edge over our monthly saver simply because they have given their money more time to accumulate dividends and build up that snowball effect of compounding.
Again though, most of us think about investing in terms of our monthly expenditure. In that sense, setting up a monthly savings plan into your investments would have been simple and efficient over these 20 years.
The clear downside of holding out for a better price tomorrow is that, quite often, tomorrow never comes. We are better off accepting we'll likely never catch the highs or the lows. The in-between can be a very useful place to be anyway.
Just to really drive home the point, research from fund house Schroders on this side of the pond highlights just how precarious it can be to jump in and out of the market instead of letting that compounding effect work its magic.
Looking at three UK indices from 1986-2021 the asset manager found those hopping in and out of the market could have ended up around £33,000 worse off than their compounding comrades.
Past performance is not a reliable indicator of future returns.
Source: FE, as at 17 Aug 2022. Basis: bid-bid in local currency terms with income reinvested.
The point to all of this is that, when we say lump sum investing, what we're talking about is investing now, with a view to harnessing the power of dividend compounding over the long term. History shows us that the longer you give your money to grow, the greater that snowball effect is.
What we're not talking about is waiting on the side lines with that lump sum, waiting for the 'wrong time' to pass and the ‘right time' to jump in. The big difference between the two is that we want the most amount of time possible to take advantage of compounding and we'll sacrifice the perfect entry point as a result.
Timing the market looks for that entry point and sacrifices time instead. What happens if it never comes though? While you're still waiting, others are already gathering dividends and reinvesting them.
So, what if you've got a lump sum and don't want to time the market, but you're worried about the near-term environment?
There is a bit of a halfway house.
What you could do is spread those investments over a year. That way you ease into the market and will have put the whole sum to work in 12 months' time. If prices drop over the year you'll be able to buy at a lower level, conversely though, if they rise you won't benefit as much as if you had invested everything at the start. In the end, it's a trade off, to allow for the unknowable.
According to research from Northwestern Mutual, lump sum investing beats pound cost averaging around 75% of the time. But, by now, hopefully it's clear that we have to factor in our personal circumstances here too.
Investing regularly into a set of assets takes the decision-making out of it all. It's also a great habit to stop you fiddling, getting stuck in the headlights or trying to time the perfect entry point.
It can be a particularly valuable way to invest during a bear market. There's no telling when the market will snap out of its bad mood so edging into the market regularly means you don't have to rely on your crystal ball.
You might have a string of lower prices but at least you aren't pinned to the first (and highest) price. What's more, as the market starts to rise, you'll break even quicker as you've been able to steadily reduce your average price.
If you've decided regular investments are for you, automating it just means one less thing to think about. And that's more than just a time saver. We tend to get emotional about money and either act rashly or freeze when we have to make decisions on the spot.
Setting up automatic recurring orders means you can leave the emotion at the door and let the process do the work for you. And remember, you can adjust those sums according to how much you can realistically afford throughout your life.
One of the big milestones for long-term investors is that magical millionaire status. There aren't many ISA millionaires out there but those that have the badge often maximise their ISA contributions through regular investing over the tax year.
Opening our maths books again, here's an example of how an ISA investor could reach that £1,000,000 investment portfolio. It's not a cast-iron route to seven figures by any means and even if it's not your goal of investing, it still serves as an illustration of what a steady, long-term investment plan could deliver.
Putting your cash to work over the long term makes the most of the magic of compounding. Source: Freetrade, 2022.
So, given the merits of contributing regularly to our investments, how do you make it happen on your Freetrade app?
Here are a few details that might help you get started.
Powered by standing orders, this feature is the first step on our journey to make long-term investing even more accessible for everyone.
Standing orders occur regularly and will continue to be deducted from your bank account as per your instructions. You can choose the day of the month they are deducted, the frequency, and the amount.
You can navigate to see all of your recurring orders from your Portfolio screen. From there, you'll also be able to deactivate any recurring orders you no longer want.
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