An unexpected windfall — whether it be from an inheritance or a work bonus or a particularly fruitful search down the back of the couch — is a great opportunity to boost your investment portfolio. For many, it is this scenario that gives them their first opportunity to start investing. Aside from where to invest, the question you’re faced with is whether to invest the money as a lump-sum or drip feed the money over a period of time — a process called pound-cost, dollar-cost or unit-cost averaging.
This article investigates both of these options and looks at the statistical and psychological factors involved. Investing everything at the top of the market only to watch its value shrink will probably make you sad, but so will a failure to pull the trigger at the start of a bull run. When assessing future scenarios, an awareness of your emotional reaction to those scenarios is as vital as understanding their likelihood.
Pound cost averaging vs lump sum
Pound-cost or dollar-cost averaging is the process of gradually investing a sum of money over a period of time. When you invest a sum all at once, you purchase your investments of choice at the price they are at the time. Whatever that price is, it is the price your return on that investment will be measured against until you sell it.
By breaking up your investment and making a series of purchases over a period of time, your investment is spread across a range of prices and the final number your investment’s performance is measured against is the average of these prices. This is pound-cost averaging.
(Investing your surplus income at the end of each month is NOT pound-cost averaging. That is merely making a series of regular lump-sum investments. Pound cost averaging refers to dividing a lump-sum of money you already have and investing it over time. Likewise, employer pension contributions that are invested on a fixed schedule are out of your control. The results mimic the effect of pound-cost averaging but do not give you the choice of a lump-sum approach.)
Pound Cost Averaging Examples
To give a simple example, let’s say your dear Auntie Agatha sadly passes away. In her will, she bequeaths you $10,000 with the condition that you invest it all in Alphabet Corporation, in the mistaken belief that they make the soup that brought her such joy as a child.
On the day you receive the money, Alphabet’s share price is $100.
Scenario 1: you decide to invest it all in one go, locking in the investment at $100 (let’s ignore fees and such for now). You now have 100 shares (100 x $100 = $10,000) of that humble soup-making conglomerate and it is relatively straightforward to judge how well your investment is doing.
Over the next year, Alphabet sell a lot of soup and excite pundits by announcing their investment in blockchain technology to bring greater trust and transparency to the soup industry. The shareprice rises to $120, and your investment also increases by 20% and is now worth $12,000. Of course, had the market been rational and seen the blockchain investment as absurd, the share price may have fallen and your investment would mirror that fall.
Scenario 2: you decide to break your investment up into five equal parts, investing $2000 a month for five months. The share price of Alphabet at each investment window is as follows:
Month 1 – $100
Month 2 – $97.5
Month 3 – $92
Month 4 – $94
Month 5 – $92
In this scenario, your final investment price is the average of the five purchase prices — (100+97.5+92+94+92)/5 = 95.1. Now, whatever the share price does you are in a better position to reap the reward of any rise and limit the damage from any fall. If the share price rises to $120 as in scenario 1, instead of a 20% return your investment is up 26.2%. Great! But wait, we’re not done yet.
Scenario 3: again you decided to split your investment into five parts over five months.
Month 1 – $100
Month 2 – $102.5
Month 3 – $108
Month 4 – $106
Month 5 – $108
The pound-cost averaging approach here gives you a final investment price of (100+102.5+108+106+108)/5 = 104.9. Now if the share price rises to $120, instead of the 20% return of scenario 1 you only achieve 14.4%. Boooo.
(Although not included here for simplicity’s sake, one variable to keep in mind is the impact of brokerage fees. If you are paying a fixed fee to your broker for every purchase, the additional purchases you make through pound-cost averaging means more fees to pay, eroding your returns.)
Does pound cost averaging work?
Well yes, it can, but timing the market is a fool’s errand that none of us ever attempt. Right? I don’t know, maybe you have an inside track on the soup industry and can accurately pick the top of the market. Remember, picking the top of a market is even harder than picking the bottom. Why? Simply because the stock market mostly goes up.
The average length of a bear market for the S&P 500 is 289 days, against an average of 3.8 YEARS for bull markets. The FTSE All-World Index has had 210 up months vs 119 down months since inception. The only scenario where pound cost averaging increases returns is where the market declines, on average, for the whole period of investment, and that is very hard to predict.
A 2012 study into pound cost averaging by Vanguard US found that for long-term investors, lump sum investing outperformed pound/dollar-cost averaging two-thirds of the time based on rolling 10-year periods.
However, it is important to note that the Vanguard study found the difference in return to be minimal. On average, lump-sum investing outperformed dollar-cost averaging by just 2.3%, which is not a lot over 10 years.
Lump-sum investing and the impact of regret
Statistically speaking, whilst a lump-sum investment gives you the best chance of maximising your investment returns, there is one more aspect to consider. As with all investment decisions, an understanding of how they will affect you psychologically is vital. Will you be overcome with regret if the market falls soon after investing a lump sum? Will market volatility stress you out?
These are not a minor considerations. Our lives are stressful enough, and an investment strategy that brings peace of mind, even at the cost of long-term returns, is worth considering. If you are prone to react to adverse market conditions, the disciplined approach of pound-cost averaging may well benefit your portfolio. Panic selling a falling investment during a market correction or crash is one of the worst things you can do for your returns.
As ever, the golden rule of investing is that the best plan is the one you’ll stick to.
Reverse pound cost averaging
As the name suggests, reverse pound-cost averaging applies to withdrawals, or stock sales, rather than purchases. Instead of selling your investments in one go, you exit your position bit by bit at regular intervals. It works in the same way – your final return will be calculated from the average of the individual sale prices.
Conclusion
Lump-sum investing will likely, for long-term investors, produce better returns by removing the opportunity cost associated with sitting on a chunk of cash waiting for the next investment window.
Pound-cost or dollar-cost averaging, by design, smooths both market volatility and your nerves. The risk of a slightly smaller return may well be worth it for a less stressful investment journey.
This article is for educational purposes only and does not constitute financial advice. Always do your own research and seek independent financial advice if required.
