If you have a ‘lump sum’ to invest, do you invest it all in one go or slowly feed it into the market over time? This is one of those questions that has more to do with your personality than finance. There really is no right or wrong answer.
Like many questions in finance, it boils down to risk vs reward. Do you invest it all now knowing that the expected return is positive (markets go up on average) or do you reduce the risk that the market suddenly falls right after you invested the whole amount? This is the dollar-cost averaging vs lump-sum investing conundrum. We can help you make the most appropriate decision if you are fortunate enough to be in such a circumstance.
Some investors favor a pound-cost averaging (PCA) approach to deploying their investment capital. Unlike lump-sum investing, in which the full amount of available capital is invested up front, PCA spreads out investment contributions using installments over time. The appeal of PCA is the perception that it helps investors “diversify” the cost of entry into the market, buying shares at prices that fall somewhere between the highs and lows of a fluctuating market. So what are the implications of PCA for investors aiming to generate long-term wealth?
Let’s take the hypothetical example of an investor with £12,000 in cash earmarked for investment in stocks. Instead of buying @12,000 in stocks today, an investor going the PCA route buys £1,000 worth of stocks each month for the next 12 months. If the market increases in value each month during this period, the PCA investor will pay a higher price on average than if investing all up front. If the market decreases steadily over the next 12 months, the opposite will be true.
While investors may focus on the prices paid for these installments, it’s important to remember that, unlike with the lump-sum approach, a meaningful portion of the investor’s capital is remaining in cash rather than gaining exposure to the stock market. During the process of capital deployment in this hypothetical example, half of the investable assets on average are forfeiting the higher expected returns of the stock market. For investors with the goal of accumulating wealth, this is potentially a big opportunity cost.
Despite the drawbacks of pound-cost averaging, some may be hesitant to plunk down all their investable money at once. If markets have recently hit all-time highs, investors may wonder whether they have already missed the best returns and so ought to wait for a pullback before getting into the market. Conversely, if stocks have just fallen and news reports suggest more declines could be on the way, some investors might take that as a signal waiting to buy is the wiser course. Driving the similar reactions to these very different scenarios is one fear: what if I make an investment today and the price goes down tomorrow?
Exhibit 1 puts those fears in a broader context. It shows the average annualized compound returns of the S&P 500 from 1926–2019. After the index has hit all-time highs, the subsequent one-, three-, and five-year returns are positive, on average. After the S&P 500 has fallen more than 10%, the subsequent one-, three-, and five-year returns are also positive, on average. Both data sets show returns that outperform those of one-month Treasury bills. Overall, the data do not support that recent market performance should influence the timing of investing in stocks.
Both theory and data suggest that lump-sum investing is the more efficient approach to building wealth over time. But pound-cost averaging may be a reasonable strategy for investors who might otherwise decide to stay out of the market altogether due to fears of a large downturn after investing a lump sum.
The stock market has offered a high average return historically, and it can be an important ally in helping investors reach their goals. Getting capital into stocks, whether gradually or all at once, puts the holder in position to reap the potential benefits. A trusted financial advisor can help investors decide which approach—lump-sum investing or pound-cost averaging—is better for them. What’s clear is that markets have rewarded investors over time. Whichever method one pursues, the goal is the same: developing a plan and sticking with it.
Please contact me at Clara Wealth Management at firstname.lastname@example.org or on 0207 097 4968 if you want to find out more or have any comments.
This article was first published on the Dimensional Fund Advisors page Dimensional Insights.
Past performance is not a reliable indicator of future performance. The value of investments may go down as well as up and you may get back less than you invest.