Investing in shares for the long term can be done two ways. You can invest one big lump, or regularly drip a series of smaller amounts in – ‘pound cost averaging’ (PCA). For example, let’s take your annual individual savings account (Isa) allowance. Rather than invest your full £11,520 for this tax year (ending 5 April 2014) at once, you could drip an equal amount (£11,520/12, or £960) in every month starting in April 2013 instead.
So which way is best? Sir John Templeton, whose Templeton Growth Fund grew at a staggering 16% a year between 1954 and 1992, used to argue that “the best time to invest is when you have the money”. But as fund manager Mark Mobius notes on Businessinsider.com, investors who have neither the skills nor confidence to time the market (buying low and selling high), PCA is best. Why?
First, you don’t have to find a lump sum if you don’t already have one, so it’s kinder on your cash flow. Once a PCA direct debit is set up, you can forget about it and let it roll – there’s no risk you’ll forget to invest. More importantly, says Mobius, it should work well in performance terms. That’s because historically “bull markets have gone up more in percentage terms than bear markets have gone down, and bull markets have lasted longer”. So while PCA will generally miss the highs and lows, it keeps you invested in stockmarkets that have generally seen more bull years than bear ones.
But there are some problems. The main one is that PCA is better at protecting you from bear markets than at making money in bull markets. Say you invest £1,000 in 1,000 shares at £1 each. A month later the price falls to 50p. Now you are £500 down. Had you applied PCA and invested the £1,000 over ten months instead, you’d have bought 100 shares in month one. They’d now be worth £50, and you’d have £900 left to invest over the next nine months. Last year, a Vanguard study of more than 1,000 rolling 12-month periods in American markets found that lump-sum investors would have seen their investment fall in value 22.4% of the time, versus 17.6% using PCA.
But if the share price had risen to £1.50, the £1,000 lump sum would be worth £1,500, whereas drip-feeding would leave you with £150 in shares and £900 left to invest. The next whammy with doing PCA into a bull market is that the £900 is missing out on stockmarket gains and probably earning a pitiful interest rate on deposit while you wait to invest. The third factor is costs: you may pay more to invest on a regular basis in total than you would with a lump-sum approach.
This explains why the same Vanguard study found that on average lump-sum investing results in higher returns than PCA, about two-thirds of the time. That was based on looking at portfolios featuring all stocks, all bonds and a typical 60/40 stocks/bonds split. The longer the time frame, the greater the chances that a lump-sum approach would beat PCA. So game set and match to lump-sum investing?
Not necessarily. The difference isn’t huge. Split £1m between shares and bonds on a 60/40 basis, and invest over ten years using each method, and lump-sum investing delivers a total fund that is only 2.3% bigger on average. So for investors who want to “invest and forget”, PCA will deliver fewer sleepless nights at little cost. However, given the option – and the stomach for it – lump-sum investing based on decent research is the better bet.