Traditional economists were fond of very simple models. They tended to assume that investors had perfect knowledge, behaved rationally and were presented with clear, obvious choices.
Practitioners of the so-called dismal art have become more sophisticated in recent years, taking human emotions and asymmetrical information into account (in other words, accepting that we don’t behave like computers and we don’t know all the facts when we make important decisions).
Bearing in mind that combination of emotion and lack of knowledge is very relevant when it comes to contemplating one of the biggest conundrums in investment: should we go all-in with a single lump sum or should we drip-feed our investments over time?
In the simple, textbook world of traditional economics, this would be an easy decision. We would invest all our money in a lump sum to take advantage of compounding in a steadily rising market.
Unfortunately, as we’ve realised, life isn’t quite that simple. So how should we approach our investment strategy in the real world?
Time is on your side
Investing is committing your capital in the expectation of a positive financial gain. With investing you benefit from the twin forces of time and diversification: underperforming or mispriced shares can recover, and investors can ride out market volatility, while holding shares for the long-term provides dividend income.
Going all-in is self-explanatory. It involves committing all your capital to the market at one time. Phasing in is the practice of investing your capital in a series of smaller, equal instalments over a fixed period of time. This technique is also known as pound-cost averaging.
The probability of volatility
In purely statistical terms, you are more likely to boost your returns by going all-in, as early as possible. Lump sum investing has been shown to outperform drip-feeding around two-thirds of the time, in relation to investment in the US and UK equity markets1. Stock market wisdom holds that getting your money invested in the market at the earliest possible opportunity gives it more time to grow. As stocks and bonds outperform cash, there is a cost to keeping your money out of the market for any period of time.
Getting as much of your money into the market as early as possible therefore allows you to take better advantage of the phenomenon of compound interest, by reinvesting your dividends over time.
However, eagle-eyed readers will have realised that phased investing works better around one-third of the time. In volatile markets, phased investing reduces the risk of losing a substantial proportion of your lump sum in one go. Regularly investing smaller amounts enables you to purchase more stock or fund units when prices are low and fewer when prices are high. This could reduce the average cost of investments over time if the pound-cost average works in your favour.
Winners and losers
Choosing the appropriate strategy depends to a large extent on the emotional resilience of the individual investor.
In other words, your grief at losing a GBP20 note would be double your joy of finding that amount.
This so-called loss aversion principle is at the root of which investment strategy will work best for you. If you are worried about investing at the wrong time – for example, you dread committing your entire investment pot on the day before a market crash or a major correction, then phased investing would be the better option. The merits of this approach could be seen in the immediate aftermath of the financial crash of 2008 when the FTSE-100, the main UK equity index of the 100 largest quoted companies traded on the London Stock Exchange, recorded single day rises and falls of up to 9 per cent2.
If you are at the more risk-averse, cautious end of the investor spectrum, then drip-feeding provides you with reassurance that you have some protection from the downside of volatile markets.
A word of caution is required for all investors during volatile markets.
That is strictly for gamblers, not investors. Rather, it is the amount of time that you are invested in the market that counts.
Volatile markets provide good opportunities for astute investors. History shows that diversifying your investments across a range of asset classes – from equities and bonds to property – and committing to a long-term investment strategy like discretionary investments, rewards those investors who stay invested irrespective of the entry point.
For help or advice with your investment strategy, speak to your Relationship Manager or Investment Counsellor.
1Dollar Cost Averaging Just Means Taking Risk Later: Vanguard Research
2London Stock Exchange: FTSE Index Historic Closing Values