It’s a question I get pretty often: ‘I have a lump sum to invest, should I invest it all at once, or phase it in over time?’
It’s another one of those questions which I love because there isn’t really a wrong answer. Either way you are getting money into the market, and with a long term view this can only be a good thing.
But to figure out which is the better option, let’s look at the two (usually opposing) forces which generally apply to personal finance and investing – the numbers, and the softer issues (like risk appetite, personal situation and goals).
Investing a lump sum vs over time – the numbers
There is pretty much only one sure thing about long-term investing – markets move higher. That’s what they are designed to do.
Let’s look at some pretty pictures (captured on May 27 2020).
Here is a long-term chart of the S&P500
Source: Trading Economics
Yup – over the long term that’s pretty much a one-way street; same idea in South Africa.
Here is the Top40
Source: Trading Economics
And heck, even them Aussies get it right.
Here is the ASX 200
Source: Trading Economics
So pretty much across the world, over the long term, the markets head toward one direction (and it’s not the band).
Despite numerous setbacks along the way, the magnetic pull of human innovation, efficiency and determination suck markets higher than what many people can imagine.
So visually and (hopefully) intuitively, markets move up a lot more than they move down. So putting your entire lump sum in the market means that you are far more likely to be catching an upward trend than a downward one. So from that perspective, it makes sense to get a lump sum of money into the markets as soon as possible rather than by phasing it in over time.
And if you want more hard numbers around this thinking, there was a pretty in-depth study done by Vanguard which compared investing a lump sum with phasing the investment in over a year for three different markets (the US, Australia and the UK). It then checked how the performance of each strategy would have done, using a whack of historical data (sometimes going as far back as 1926) .
It summarised the results into a cool picture (it uses the word ‘systematic’ to describe phasing in an investment over time – fancy).
More often than not, it has paid to invest immediately.
Systematic investment over a 12-month interval and a 60% stock/40% bond portfolio
Source: Vanguard calculations, using benchmark data.
The results are pretty conclusive – around two-thirds of the time you would achieve a better outcome by investing everything right at the beginning, instead of phasing it in over time. And the average magnitude of out-performance is around 2%.
To summarise the numbers part of it then: On average, the average investor will do better by investing a lump sum immediately instead of phasing it into the market.
But here’s the problem though – who wants to be average?
People who are considering a phased-in approach are maybe not that concerned with average outcomes, and more concerned with worst-case scenarios. If this is a large lump sum (compared with the rest of your portfolio) or if your future contributions are small by comparison, then the ~33% of the time where the lump sum investment does not beat phasing in, could mean an entire plan is derailed.
For example, if you had a lump sum and decided to invest it all into a New York Stock Exchange index tracker right before the start of the global financial crisis, it would have taken you until November 2013 to recover your initial investment. That’s six years just to break even. If that money was earmarked for retirement, or a child’s university education, it might be time for plan B (where B stands for baked beans). In this case it could be worth paying the out-performance premium of around 2% for some protection should markets hit a wobbly.
In the above scenario, phasing the investment in would have given a far superior outcome because you would have bought each month at a better price as the markets fell, and got more units for your rands.
But for most people with a long time frame, [who are] still making other monthly contributions to their investments, the numbers say you should go all in.
Personally, I am a numbers kind of guy (an engineering degree will do that to you) and so I would just go all in with a lump sum investment (if anyone wants me to prove this by donating a lump sum, get in touch I will send you my banking details). But personal finance is personal, and often it is not just about the numbers. So let’s take a look at some of the other aspects.
Investing a lump sum vs over time – the softer issues
Your risk appetite
Throwing a large sum of money into riskier assets like equities can be a daunting prospect. Depending on your risk tolerance, seeing a market decline right after you have thrown the kitchen sink at it would give many people sleepless nights. If you think that the stresses of the daily movements of the markets would cause you some anxiety, then phasing in the money over time might be a better bet.
Where does the money come from?
In theory, a rand is a rand is a rand – it doesn’t matter where it comes from. But in practice it doesn’t always seem this way. For example if you received a lump sum as an inheritance, there could be a lot of emotion attached to it, and seeing it lose value right after investing it all could leave you with regret and a feeling of irresponsibility and guilt. In this case you may prefer to phase your investment in.
The amount of money
If the lump sum amount is large compared with your current investments and/or your future contributions, and you invest it all at once only for the market to fall, it could be difficult to recover from. Even though over the long term you will likely still achieve a better outcome by going all in, the short-term market gyrations will really move your profit and loss needle, which could be scary to watch.
If the amount of money is relatively small compared with your investment portfolio, it may be easier for you to throw the entire lump sum in at once.
What is defined as a ‘small’ or ‘large’ lump sum will vary from person to person.
Investing a lump sum:
- On average achieves a better outcome
- It is riskier, especially if you don’t have any more money to add, or the lump sum is large enough to dwarf your existing investments and future contributions.
Investing over time:
- On average performs worse
- Carries less risk in the event of a market downturn.
It seems like a classic risk versus reward trade off that applies to almost all aspects of investing. Only you can decide if the extra reward is worth the extra risk.
But perhaps the most important thing to remember about all of this is that both investing a lump sum all at once, or splitting it up and doing it over time, beats the other alternative of ‘doing nothing’.
This article was first published on Stealthy Wealth here, and republished with permission.