A typical question I get asked quite a lot is this: Should I invest my money at once or over time (e.g. monthly)? Here’s an e-mail I received:
I am very keen on making my money work for me and have just recently started doing my research on becoming FI. Hoping your emails can help me towards this! One of my main queries is around investing, should I start with a lump sum of my savings i.e £2k straight off the bat or invest small amounts monthly i.e £300 a month?
Investing all at once is often called ‘investing a lump sum’. And to cut the long story short, yes, the research shows that it’s more profitable to invest the lump sum at the beginning than splitting it over X months or years. But there’s so much more into it than a clear-cut ‘yes’.
What if the market crashes just after you invest your lump sum?
What if the market crashes just after you invest? Or what if it slowly declines over the next 12 months? That would surely favour the splitting strategy, or in technical terms: dollar-cost averaging* as they call it.
In fact, it’s a question I keep asking myself every April which is when the tax year resets here in the UK. Being a software consultant means that I can receive most of my year’s salary at the beginning of the tax year. After deducting all the expected expenses for the year, the amount dedicated to investing just stares at me as a lump sum. What do I do??
If you have non-volatile investments (say you put your £20,000 in a Santander 1.5% account) then obviously, investing a lump sum as soon as possible is a no brainer. But most of the inflation-beating investments are volatile and you can actually lose money short to mid-term. So this is an important topic to consider.
Sure, if the market crashes after you invest a lump sum then you’re probably worse off. But what if it doesn’t? What happens most of the time?
The above chart shows the annual returns of a global 60/40 portfolio for the past 33 years. Courtesy of the excellent Portfolio Visualiser website.
If history is any guide, the market goes up longer than it goes down. By not investing a lump sum as soon as you can, you’re effectively choosing to bet on trying to avoid the negative years of the graph above. But in the attempt to avoid the downside, you’re missing out on the upside, which is more likely to happen according to history.
In fact, for a 60/40 portfolio (and quite similar for a 100% stocks one), investing money at once beats investing it over time two-thirds of the time (Vanguard study, 8-pages analysis). By how much does lump-sum investing outperform? For UK investors, that’s 2.2% for the 12-month period of investing monthly. For US investors, that’s 2.3%.
But investing is (mostly?) psychology too
Investing a lump sum is not an easy call. Psychology plays a huge role here. And successful investing is 50% psychology, 50% finance. The best investment strategy in the world will fail to produce its great results if you fail to implement it because of fear or greed.
And successful investing should be often geared towards minimizing regret than maximizing your money pot. I’d rather sleep better at night than have a stressful investing experience that after X years will give better results.
But shouldn’t you incorporate this psychology protection in your investments anyway? I mean, a portfolio should be cautious enough that you’re not afraid of adding more money into it! To make a portfolio more defensive add lower returning assets such as short-term government bonds and perhaps gold. Diversify by adding property into the mix.
Cash is not the best strategy if you’re going to deploy the money in investments anyway. Delaying your investments is actually a form of market timing. And I quite like to refer to the quote:
Market timing means that you invest according to the belief that holding cash will beat your investment portfolio. Cash is a position. So you’re taking a position that your cash will perform better than your investments until you’re fully invested. Very few investors succeed in market timing.
Also holding cash means that your portfolio allocation has now changed. Say you have £50,000 invested in property and you receive a bonus at work of £50,000 (where do I apply? 🙂 ). Now you are 50% property, 50% cash. Your asset allocation has drastically changed.
We saw how investing a lump sum immediately is better than investing over time from a pure math point of view. Therefore, if an investor is happy with their asset allocation and not afraid of contributing more, then putting their money to work faster is better than delaying it.
Lump-sum investing work out better 66% of the time.
However, if an investor wants to protect against the downside risk they’re better of splitting their investments in chunks over time. This will minimize regrets and risk. If you end up following this strategy, then it’s also a good idea to revisit your portfolio allocation and give it a more defensive mix. You’re taking more risk than you should for your investor profile!
*dollar-cost averaging as a strategy is great for investing a recurring income (e.g. your salary). It smooths the ups and downs and you’re buying more shares when the market is down, and fewer shares when it’s up.