Lump Sum vs Drip Feeding
So, you’ve found yourself with a wad of cash to invest in the stock market – you lucky so and so!
And being a smart investor, you’re aware of the perils of trying to pick winning companies, and you’ve wisely decided to invest in index funds
But now you’re faced with a new dilemma: do you invest all your money at once, or do you drip feed it into the market over a period of time?
Which strategy is going to give you the best return? Which strategy is safest?
Arghhh! It’s decision after decision after decision.
In today’s post, we’re going to settle the debate on lump-sum investing vs regular contributions once and for all.
So, without further ado, let’s get into it…
What is Pound Cost Averaging
Most people invest by making regular, automatic contributions to a fund, whether it be through a pension or ISA.
Whether knowingly or not, these investors are benefitting from pound cost averaging.
When the market is falling, their regular contribution is going to buy more units.
And of course, when the market is rallying, their money will purchase fewer units.
By drip-feeding their savings into the market, these investors will pay the average price for their investments over the long run, which is known as pound cost averaging.
But what if you’re sitting on a lump sum of cash to invest; should you continue with the slow and steady approach, or just “drop it likes it hot” and buy a bunch of assets all at once?
Let’s have a little fun answering this question with a hypothetical investor, who we’ll call Bob.
Bob is a 27-year-old salesman who has just recently started taking an interest in personal finance.
Bob has made major progress lately paying off all his consumer debt, building an emergency fund and he’s just saved £10k.
Well done, Bob! You absolute legend.
Bob is super excited to start investing and has decided he’s going to invest in a FTSE 100 index fund.
It a smart move as by buying a tiny piece of each of the biggest companies in the UK, Bob has acquired a diversified portfolio and is not subject to the risk of any one company going bust – Bob has clearly done his homework
Bob’s now debating whether he should invest all his £10,000 savings at once, or invest £1,000 a month for the next ten months.
The two paths Bob could take are shown in the graph below.
Scenario 1. Bob Goes All In
If Bob were to invest all his savings in a oner (represented light blue), all his shares would be purchased at the same price.
The pitfall with this approach is that Bob has no idea which direction the market is going to take after he’s allocated his capital.
If the market rises, he’ll feel like a genius and forever be giving out stock tips at his local boozer.
If it falls, he may panic sell at a loss, and then be petrified of ever investing in shares again.
Timing the market is incredibly tricky. Financial analysts whose full-time job is to predict which direction the market will go regularly get it wrong.
If you bide your time and try to buy into the market when it’s favourable, you could potentially be waiting years to invest, and there’s a chance that you’ll call it wrong.
Scenario 2. Bob Drip Feeds
If Bob were to invest £1k every month for ten months (represented dark blue), he’s going to purchase assets at varying prices depending on what the market is doing.
When the market falls, his £1000 is going to stretch further.
It’s for this reason that Bob doesn’t fear stock market tumbles; when stock prices crash, he’s essentially buying them on sale
When the market climbs, Bob’s £1000 investment won’t be able to purchase as many shares, but he’ll also benefit from the growth of the shares he bought at a “discount”.
So, Which Strategy Is Better?
In the above example, stock prices fell over Bob’s ten-month investing period, which resulted in Bob owning more shares than if he were to invest in a lump sum.
However, if the opposite was to happen, and the share price rocketed after Bob invested his £10k, then Bob’s regular £1k investment wouldn’t buy as many shares, and he would be worse off.
Which strategy is better depends on the point that you enter the market.
Pound cost averaging wins when the market is declining. Lump-sum investing wins if the markets take off after you’ve invested.
But as I’ve already mentioned, no one can accurately predict what way the market will swing.
There are billions of factors at play that influence how global markets react, and not even the greatest investors in the world can correctly call which way the market will go 100% of the time.
Timing the market as a strategy is a terrible one.
On the other hand, drip-feeding your money into the market allows you to hedge your bets.
You’re going to “win” sometimes and “lose” others, but you’ll do just fine over the long term.
And if you pay attention to the markets, there’s nothing to stop you from topping up your regular contribution when stocks are cheaper, and pulling back when they’re on the rise.
There’s also the psychological aspect to consider.
Most people would be less nervous investing £1,000 a month than investing their entire pot at once.
And at the end of the day, your investments should be making you feel secure and not keeping you up at night.
The Final Word
In my opinion, regularly accumulating assets is the better option. You’re better off hedging your bets instead of praying that your timing is spot on.
Knowing my personality and risk tolerance, I feel much more at ease making regular contributions than chucking all my savings into the market at once.
However, there’s nothing wrong with investing a lump sum if you have a long investment timeframe.
Time in the market is much more important than timing the market when it comes to overall returns.
If you start investing young, 30+ years of regular investing and compounding will negate any big wins you would have made from correctly timing the market.
So, don’t sweat the small stuff, keep calm and carry on investing.