Image by Karolina Grabowska from Pixabay

One of the questions which clients frequently ask when contemplating investing a lump sum is when they should do it.  They may have received proceeds from an asset sale, an inheritance or a bonus and these may be substantial in value.  Consequently, and unsurprisingly, they are often concerned as to the potential impact on their future security if the market crashes shortly after they have invested.  This is particularly the case if they do not anticipate being able to replace the cash they have received if that happens, such as if they have sold a business and given up paid work.

While we have long argued that nobody can predict reliably when the best time to invest is (other than when you have the money), one option that is often suggested is to spread the investment over a period of time.  This is typically suggested to be over six months or a year, the purpose being to minimise the risk of investing everything just before a market fall.  Since the approach apparently originated on the other side of the Atlantic, it is commonly known as dollar cost averaging (DCA) although it could equally be known as pound, zloty or kwacha cost averaging depending on your local currency; the principle is the same.

The chart illustrates the conceptual difference between the two routes, here for an investment of £600,000 in total, spread over 12 months compared to being invested at outset.

Data source: Bloomsbury

While such an approach looks attractive in that it reduces the stress which people can feel having just invested their life changing lump-sum only to find that it is now worth less than it was yesterday, the rational response to such a question is that it should be invested all at once.

The appeal of the DCA approach is that when buying an asset which fluctuates in price, there is a greater possibility of purchasing it at attractively low prices than there is if trying to pick the single best date on which to invest.  Since it is well established that there is no reliable way to pick the best date, picking 12 over the course of a year appears to increase the prospect of doing so compared to picking just one date.

If the price of the asset falls during the period over which capital is being dripped into the market, the investor will pay a lower price on average than if they had purchased at the start of the period.  Conversely, if the price rises over the period, they will pay a higher average price.

However, as investors, we expect that over our anticipated time horizon time the asset which we are purchasing will increase in price.  After all, if we do not expect that, it is reasonable to ask ourselves why we are investing at all.  If we look at a long enough historical period (such as multiple decades), we can observe that stock markets have indeed generally risen in about three times as many years as they have fallen.  Of course, while predicting exactly when the rises and falls will occur is practically impossible, given this ratio between positive and negative years, the odds of DCA working in your favour are three to one against you.

Chart shows S&P 500 index, capital only.   Data source: DFA ReturnsW

As the chart shows, even in years which have seen significant market falls, in the majority of those since the turn of the century the returns (in the US market at least) have been positive.

Of course, regardless of the mathematical element, it is when markets are falling that it is hard for logic to take charge of emotion and even if you had the intention of continuing with your monthly investment, it can be difficult to keep this up after several months of falls.  If you bale out of the strategy because you are struggling to cope with the fluctuations, it is irrelevant how well it might have worked for you.  This is true whether you have invested at outset or you planned to do so gradually.

The simple fact is that if prices are expected to rise over your investment timeframe, the shorter the period that your cash is invested, the lower the growth that you will achieve.

So much for the theory; what about the actual results?

Well given what we said above, it should not come as a surprise to see that compared to investing a lump sum at outset, the DCA approach has outperformed in a minority of years.  Indeed, the only times in which it outperformed lump-sum investing for a typical portfolio with 60% in equities and 40% in fixed interest assets were when the market fell substantially, such as in the 1973-74 oil crisis, the 1987 Black Monday, the 2001 end of the dotcom boom and the 2008 global financial crisis.

It is certainly reasonable to be nervous of market corrections, particularly if you are new to investing and your experience is influenced by media stories about billions being wiped off stock market values.  However, over typical investment time horizons, markets generally rise and those rises can occur in relatively short periods – if you aren’t invested on those days, the pattern of your returns can look very different.

It is natural to be concerned about losing money and this is why any financial planner worth their salt will take some time to determine and discuss with you the appropriate amount of risk for you to take with your portfolio.  This needs to strike a balance between the amount of risk that you need to take to achieve your goals, the risk that you are comfortable to take without panicking and the extent to which you can afford to suffer a financial loss.

Since we have established that investing a lump sum is likely to deliver a higher return over typical investment horizons than feeding the cash in gradually, a better approach may be simply to have a lower exposure to the volatile assets such as equities and increase your exposure to defensive assets such as short term bonds.  The extent to which a particular mix is appropriate for you will depend on your circumstances, which is why investing is an activity best undertaken in the context of a well structured financial plan which is then reviewed regularly to keep you on track.

This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person.  Your capital is at risk when investing.  Past performance is not a reliable indicator of future results and forecasts are not a reliable indicator of future performance.

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