Pound cost averaging versus lump sum investing: which is the best way to save?

Egg timer filled with monetary coins

When discussing investments, there is a tendency to use big numbers, as anyone who has spoken to an adviser about a 'meagre' £50,000 pension pot can attest. So it's easy to become convinced that you're not worth giving the time of day unless you have £250,000 put away.

However, most people have few opportunities in their lifetimes to invest large lump sums in one go. So if you are one of the many people whose investment effort is realistically going to take the form of regular, modest contributions from their earnings, what are the advantages and drawbacks of such a savings strategy?

If you don't have a lump sum, but you do have some spare income, monthly direct debits from your current account into a regular saving scheme are a practical, painless and hassle-free way to get into an investing habit. And the fact is that many small contributions can build into a sizeable pot.

POUND COST AVERAGING

One key argument for regular investing is the effect of pound cost averaging. Simply put, pound cost averaging allows savers to benefit from market volatility over the long term by investing a small amount regularly, because it allows them to buy units more cheaply on average.

Let's say you invest £100 a month. In the first month, the share price of whatever you're investing in is £5, allowing you to buy 20 shares. If the share price falls to £4 in the following month, you will buy 25 shares, leaving you with 45 shares and a smile on your face when the share price rises again.

If you had initially spent a lump sum of £200 on the shares, you would now have just 40 shares. In a volatile market, the average price per share tends to work out lower when you save regularly - in this case the price per share is £4.44 against £5.

Pound cost averaging is sometimes also touted as an investment strategy for people in a position to choose between investing everything in one go or holding cash and drip-feeding it into an investment to avoid the pain of full exposure to a market downturn. However, as with most aspects of investing, there are several factors to consider here.

It is true that regular investing can mitigate the effects of downward share price movements, but it also limits gains in a booming market. If you had invested that £200 only to see the £5 share price double over the next month, you would be sitting pretty, with 40 shares now worth £10 each, a total of £400.

In contrast, a regular investor's £100 monthly contribution would have bought 20 shares at £5 in the first month but only 10 at £10 in the following month, a total of 30 shares worth £300.

This suggests that the 'lump sum versus regular investing' debate hinges on market conditions when you invest your money.

It is notoriously difficult to time the market, and impulsive investing is, statistically speaking, one of the worst money habits you can have. Lump-sum investors tend to take a more impulsive, market-timing approach to investing that can be counterproductive.

In contrast, regular investors develop the habit of investing money each month regardless of market conditions.

'There is an advantage in that it's habit-forming and has an impact on behavioural investing,' says Martin Bamford, managing director at financial planning firm Informed Choice. 'If you invest a lump sum, your behaviour becomes about buying and selling. If you invest regularly, you are less likely to react. It's a really powerful way of investing money.

'The act of investing regularly may also make people pay more attention to their portfolios, whereas if they make a one-off investment, they can become too short-term focused,' he adds.

However, one of the factors that benefits investments most is time in the market: investing for the long term is one of the most rewarding habits you can acquire. So are you better off investing a lump sum for many years than drip-feeding the same amount overall into the market over time?

LUMP SUM INVESTING WINS OUT LONG TERM

Unfortunately for regular investors, the data suggests you are. Several studies of various portfolios over different periods have found that investing a lump sum and leaving it invested will in most cases net you a greater return than you would get investing fractions of that sum regularly over the same period.

A study by Vanguard in 2012, for example, found that lump-sum investors won out two-thirds of the time.

Abraham Okusanya, head of platform and investment research at Finalytiq, used historic performance data and found that lump-sum investors' returns far outstripped those of regular investors, even over periods that included the market crash in 2008.

In some cases - specifically, longer-term scenarios - the total return for lump-summers was more than double that for regular savers.

For example, he compared the return from investing £1,666 every month between May 2005 and April 2015 in a portfolio of global equities, with the return from investing £200,000 (the same overall sum) up-front in the same assets.

While a regular investor would have ended up with £290,000, investing the full £200,000 in one go would have produced a total of £380,000.

The disparity was greater when the £200,000 was invested over longer time spans. Over the 20 years to 30 April 2015, a lump-sum investor would have come away with £500,000, while a regular saver, making 240 monthly payments of £833, would have skulked off with just £320,000.

Over 30 years, that differential was even more pronounced. A lump sum investor realised £1.15 million for a £200,000 investment, while an investor making 360 monthly deposits of £556 ended with £440,000.

DISTINCT ADVANTAGES

The fact that this disparity seems more pronounced over time shows that lump-sum investors enjoy two big advantages. One is that their entire investment is in the market for longer, and because stocks tend to go up over the long term, fully investing as early as possible means their entire investment is exposed to this upside.

The second big plus is that the power of compound returns on the whole sum means your capital growth rolls up quicker than it does with incremental injections, while more reinvested capital gets straight to work generating further returns.

An additional potential advantage with lump-sum investing relates to cost. Regular trading costs can erode your capital significantly over the long term.

That said, many platforms don't levy trading costs, so if you take a bit of time to ensure you use the platform best suited to your investment style, costs might not be a major problem. Also many platforms accept minimum regular investments as low as £25 a month.

Despite the disadvantages of regular investing relative to lump-sum investing, there are some pluses with investing regularly. Regret and worry can impair our psychological wellbeing.

The security that comes with a Steady Eddie approach might give some investors more peace of mind. A portfolio purchased with a lump sum rises and falls with the markets, while an incremental portfolio tends to exhibit a smoother - if slower and less impressive - rise in value.

Notice that the above examples are based on longer periods. If you are trying to decide between investing annually or monthly, the advantages of front-loading may not apply, as markets can be more volatile over one year than over 10 years.

TIME IS OF THE ESSENCE

Remember, the key factor is time in the market. There is no sense in saving up so you can invest a lump sum later, rather than investing what you can immediately. 'The best time to invest is now,' says Bamford.

In the end, if you have the money to invest a sizeable sum for the long term, the statistics suggest you will be better off investing it all immediately, as the investment is likely to benefit from time in the market.

But if you would rather avoid the stress of risking the whole sum or the regret you might feel if markets fall, incremental investment may suit you better. And if you don't have a lump sum, don't be disheartened: regular investing also has its advantages.


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