Pound-cost averaging (PCA) involves investing periodically, a little at a time. But isn't that what you do with your pension and regular share savings schemes - put away a little each month, ideally using your full allowance each year?
It's not entirely the same. People portion out their pension contributions because they usually don't have the cash to pay in the whole lot in one month. And the government limits how much they can contribute each year, so they have to spread contributions out over a long time.
PCA is a bit different. When people have a big bundle to invest, instead of plunging headlong into the market, they often pay in smaller chunks spread over time. The theory is that PCA protects you from investing it all on a 'bad' day.
For example, you might accidentally invest at a relative market high just before a big correction, or worse, at the top of a bull market.
We all know we don't want to 'buy high'. Pound-cost averaging reduces the risk of getting 'all in' on a bad (expensive) day, by spreading out your cost base over time.
But does that actually improve your returns over time? Probably not. However, it definitely increases transaction costs - and that alone reduces performance.
PCA goes in and out of favour. When markets are strongly rising for a long time, as they did in the late 1990s, people tend to forget their fear of the 'bad day'. PCA usually comes surging back in popularity in bear markets or afterwards, when investors are particularly fearful.
During boom times, the only people usually talking up PCA are unscrupulous brokers who want more commissions or people who haven't studied the facts and don't know any better.
But if it's in the interest of managing risk, maybe it's worth paying a bit more? The trouble is, plenty of studies have shown that PCA doesn't reduce risk or improve returns.
A particularly good and thorough study was done a number of years ago by Michael Rozeff (former professor of finance at the University of Buffalo).
For the period from 1926 to 1990 (before the big 1990s bull market), he compared the results from doing a single, lump-sum investment each year to averaging stock purchases over each 12-month period. A whopping two-thirds of the time, the lump-sum method was more profitable than PCA.
And, for the entire period, the lump-sum approach got a 1.1 per cent higher average annual return, which is huge when you start compounding returns.
My firm has conducted its own studies more recently, with similar conclusions. We compared lump-sum investing at the beginning of a 20-year time horizon with PCA, parsing the initial investment out equally for the first 12 months, from 1926 to 2009, with the uninvested portion earning cash-like returns.
By our analysis, lump-sum investing does better 69 per cent of the time. And that doesn't factor in PCA's potentially higher transaction costs, which can skew results even more in favour of lump sums.
PCA IN PERIODS OF FLATNESS
People often wrongly think the 2000s was a period of flatness, because overall, stocks ended about where they began the decade. Wrong! There was big volatility along the way. And they also wrongly think that because the last decade ended with stocks no higher than at the beginning, the next decade will also be 'flat'.
Again, wrong. No-one anywhere has the ability to forecast stocks that far out. And what just happened isn't predictive of what will happen. But even in a period of flatness, PCA doesn't really help at all.
The interest gained from holding cash tends to largely equal the higher transaction costs. PCA really only helps if you know there's a falling market ahead. And if you could forecast that accurately, what do you need PCA for?
Simply put: lump-sum investing, over time, is far more likely to yield better results. Not every year, but often enough to make PCA fully irrational. The reason is simple: more often than not, stocks move higher. You benefit from being invested more of the time than you do from trying to avoid near-term wiggles.
Most investors acknowledge that in the long term it's about time in the market, not timing the market. So why do people suddenly fall prey to PCA? It goes back to what I've said frequently: people feel the pain of financial loss more than twice as acutely as they enjoy a similar-sized gain.
Investors might be inclined to accept an inferior strategy if it can reduce the possibility of making one big mistake that makes them feel terrible in the near term.
After all, jumping in on one bad day would cause a lot of regret. Sometimes, investors do extremely weird and irrational things just to avoid the possibility of the pain of regret - even racking up unnecessary transaction fees and hampering long-term performance.
It's not rational, but it happens. But you can avoid falling prey by remembering your emotions are your number one enemy in investing, always.
And if you do make a very poorly timed lump-sum investment, remember, bull markets over time overwhelm bear market losses.