Lump Sum Investment Or Regular Contributions – Which Is Best?
Many investors, when receiving a financial windfall face a dilemma: How should they invest this newfound cash? Should you invest the entire amount right away, as a single lump-sum, or would it be wiser to spread your investments over a series of regular contributions?
With interest rates on cash savings now above 5% and markets fluctuating, it's natural to feel anxious about investing. You might prefer the perceived safety of cash savings. But when it comes to long-term goals, it's crucial to consider if cash savings alone will meet your financial needs. That's where regularly investing smaller amounts can make a big difference.
Instead of investing a lump sum all at once, making regular investments helps you buy fewer units when prices are high and more when they're low, effectively averaging out the cost. This strategy, known as pound-cost averaging, is especially useful in volatile markets. It also eases the stress of investing a large amount right before a potential market drop.
Even seasoned investors struggle to time the market perfectly; selling just before prices drop and buying just before they rise. This challenge is magnified during market volatility, where big swings can happen day-to-day.
A recent research paper by Vanguard (which can be found here) delves into this very dilemma. The paper examines the performance of both pound cost averaging and lump-sum investing across various markets, historical periods, and simulated return scenarios. The conclusion of this paper came as a surprise to many investors.
What is pound cost averaging?
So, what is pound cost averaging? Imagine you have £5,000 you want to invest in a particular share, with a value of £50 each. You have two choices:
You could invest the entire £5,000 in one go, buying 100 shares at £50 each. While this might seem straightforward, it means you're fully exposed to the market, and the value of your investment will fluctuate with any changes in the share price.
Alternatively, you could invest your money gradually, say £500 each month over 10 months. If the share price stays at £50, you'll buy 10 shares each month. But here's the beauty of Pound Cost Averaging: By spreading your investment over a series of contributions, any movement in the share price has less impact on your overall investment. This means you're less exposed to market volatility.
Share prices rarely remain static. When you invest regularly, you end up buying more shares when prices drop and fewer when prices rise. For instance, if the share price falls to £45, you'll buy 11 shares, and if it rises to £55, you'll buy 9 shares.
What are the benefits of making regular contributions?
Financial markets are unpredictable, with prices moving up and down, sometimes even on an hourly basis. This volatility can be nerve-wracking for many investors, especially those taking the first step on their investment journey. By drip-feeding your money into an investment over time, you spread your purchases across various prices. This means you effectively pay the average price over a fixed period, helping to smooth out the effects of market volatility.
One of the great benefits of regular investing is that your buying power increases when the share price falls. This means you get more value for your money during those dips in the market. Instead of worrying about timing your investments perfectly, you can take advantage of lower prices automatically.
When markets are on the rise, investing a lump sum right from the start can be advantageous because you’re buying at lower prices, which might lead to higher returns over the long term.
But here's the catch: Markets are unpredictable, and it’s impossible to know exactly when they’ll peak or dip. By spreading out your investments over time, you reduce the risk of buying at a less favourable moment and can benefit from both market ups and downs.
By investing a fixed amount regularly, you develop a disciplined, systematic approach to growing your wealth. This method keeps you on track, making investing a regular part of your routine rather than a one-time decision.
While pound cost averaging isn't guaranteed to be the best investment strategy, even during periods of market volatility, it offers some significant advantages. One of the biggest benefits is that it's a lower maintenance and potentially less stressful way to invest. You don't have to constantly worry about market performance or try to time your investments perfectly. Instead, you can focus on your long-term goals, knowing that you're steadily building your portfolio.
So, if you're looking for a more relaxed approach to investing, pound cost averaging might be the right strategy for you.
So what does Pound Cost Averaging look like in practice?
We can see how pound cost averaging can benefit investors by looking at the example of Harry and Robert. Both have £12,000 to invest, with Harry opting to invest monthly and Robert making a single lump-sum investment. Both of them will be buying the same fund.
Harry decides to invest £1,000 each month throughout the year, while Robert jumps in with a lump sum of £12,000 in January. Over the year, the market experiences ups and downs, with the unit price reflecting these fluctuations.
By December, Harry has managed to buy over 1,000 more units than Robert, thanks to spreading his investments across different price points. As a result, Harry paid a lower average price per unit compared to Robert. This strategy not only gave Harry more units but also increased the overall value of his investment by almost £2,000 compared to Robert.
Which produces the best returns?
Pound cost averaging sounds great in theory, but how does it stack up in the real world?
A recent study by Vanguard (here) looked into the performance of investing a lump sum versus making regular contributions. They focused on investments in the MSCI World Index, which represents a broad range of shares from 23 countries and analysed returns from 1977 to 2022.
The study compared two approaches: investing a lump sum all at once versus splitting the lump sum into three equal parts and investing each part monthly over a three-month period. The researchers wanted to see how these strategies performed over a one-year investment horizon.
Here’s what they found: Lump-sum investments outperformed pound cost averaging 68% of the time across global markets after one year. This was a surprising result for many, as pound cost averaging is often praised and applied for its potential to reduce the impact of market volatility. However, pound cost averaging still had its merits. It outperformed keeping the money in cash 69% of the time, which highlights its advantage over just letting the money sit idle. That being said, they found that investing a lump-sum has historically outperformed returns on cash 70% of the time.
The study also examined a $100,000 initial investment across three different portfolios with varying levels of risk. The findings revealed that, in most historical market conditions, investors who chose lump-sum investments would have had better returns compared to those who used pound cost averaging.
So, what’s the key takeaway? The longer the period for pound cost averaging, the more opportunity costs you might incur, and the more pronounced the performance advantage of lump-sum investing becomes. Simply put, while you’re holding onto cash with pound cost averaging, you’re missing out on potential returns, especially over extended investment periods.
Are regular investments still worth it?
This begs the question: When is Pound Cost Averaging suitable?
The study went even further by simulating 10,000 different return scenarios to explore how various portfolios and cost-averaging periods performed. These simulations revealed that, much like the historical analysis, lump-sum investments generally resulted in greater wealth after one year. However, they also came with the potential for larger losses, particularly during the choppiest market conditions.
Not all investors are solely focused on maximizing wealth, though. Some prefer a slower, steadier approach to growth if it helps avoid significant losses. To address this, Vanguard created a model to assess how different investors might respond to risk and loss aversion. They considered investors with varying levels of risk tolerance and loss aversion to determine which investment strategy—pound cost averaging or lump-sums—might suit them best.
They found that investors who have a low capacity for loss may benefit more from a cost-averaging strategy. This approach can help reduce the impact of market downturns by spreading out investments, which can be appealing to those who prioritize avoiding large losses over chasing maximum returns.
However, the research also offers a word of caution. Even if you’re someone with a high level of loss aversion, it's still wise to limit the duration of your cost-averaging period. A shorter period, like three months, can help minimize the opportunity costs associated with holding cash.
As the researchers put it, "A pound cost-averaging strategy is certainly better than keeping your money entirely in cash and can be a good fit for those who are particularly risk-averse. But given the costs of holding cash for extended periods, most investors—especially those who aren't extremely loss-averse—should consider investing their lump sum right away for potentially better returns."
In simple terms, Pound Cost Averaging, despite offering lower returns based on this research, still has a place for investors with a lower appetite for risk or capacity for loss.
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