David Prosser asks which is best.
If you are thinking about putting money into an investment company, you have a choice about how to invest. One option is a one-off lump sum investment in the fund. Alternatively, you can use regular savings schemes – available through most platforms – to pay in a fixed cash amount each month; that might be as little as £25 or £50.
So, which is the best approach? Well, the case for regular savings depends on the power of a statistical phenomenon known as pound cost averaging. By drip-feeding money into the fund in regular payments, you smooth out the ups and downs of equities. In months when the market is down, your fixed investment buys a larger number of shares, which offers some compensation for the losses incurred on previous investments. In other words, there is no need to worry about the notorious difficulty of market timing.
In practice, many investors have no choice but to embrace regular savings. If you are putting money aside from income as it comes in, or if investment limits such as caps on individual savings accounts or private pension plans apply, then you will automatically be using regular savings.
But what if you have a lump sum to invest? Unless you are supremely confident about your ability to time your investment, the principles of pound cost averaging would seem to suggest that you are better off drip-feeding the money into your chosen fund over an extended period – in 12 monthly instalments, say – rather than writing a single large cheque.
What the numbers tell us
However, academics do not necessarily agree. One landmark study, conducted by Michael Rozeff, a former Professor of Finance at the University of Buffalo, looked at stock market returns in the US between 1926 and 1990 to work out what investors would have earned from investing the same amount of money in two ways: as an upfront lump sum, or in monthly investments over the course of a year. Professor Rozeff found the lump sum approach worked best two-thirds of the time – it produced returns that were, on average, 1.1 percentage points higher each year.
More recent studies have come to similar conclusions – and there is a good explanation for this. Since the stock market tends to rise over time, you benefit more from having more money invested for longer, even accepting the risk of short-term ups and downs.
To put that another way, if the allure of pound cost averaging is that it buys you more when markets are falling, you need markets to fall more often than they rise to get the most from the phenomenon. In the past at least, that is not what has happened, at least over longer-term periods. And anyway, if you are really expecting equities to fall more consistently than they rise, the stock market probably is not the right place to be investing your lump sum.
Reassurance has value
Does that mean a lump sum is automatically the right way to go? Not necessarily – behavioural finance experts point out that the discipline of regular savings is important, and that it can help investors overcome their nervousness about committing to an asset that can fall as well as rise in value. Investors understandably tend to feel more regretful about investments that go wrong than happy about those that do well – so managing that psychological effect can be useful.
It is also the case that regular savings plans can help you avoid putting all your eggs in one basket – they make it easier to invest in a number of different funds at once. And if you are looking at funds investing in more volatile assets, regular savings also looks more attractive.
In the end, of course, it is good to have the choice. By all means, take advantage of regular savings schemes if you want or need to. But if you want to make a single one-off investment, there is no need to feel regretful about not drip-feeding it into your chosen fund over time.