Question:
Every year I add money to my ISA in a lump sum. Would I be better off using pound-cost-averaging over the course of the year?
Answer:
Pound-cost-averaging, which is a technical term for buying shares of a stock or fund in equal pound amounts and at regular intervals, is assumed by many investors and financial pros to be the best way to invest. The advantages are clear: by investing a given amount over time and in equal-sized chunks rather than all at once, the investor ends up buying more shares when prices become cheaper and fewer when they become more expensive.
For example, let's say you have £1,200 in cash to invest. Rather than invest all £1,200 at once, you could invest £100 per month for a year. Now let's say the fund you're investing in sells for £10 a share in the first month but drops to £5 a share in the second. Using the pound-cost averaging method, you would end up buying 10 shares in the first month, before the market drop, but 20 shares in the second, after the drop. Had you invested the entire £1,200 in the first month you would have owned 120 shares, which, in month two, would have declined in value to £600. In this way, pound-cost averaging helps reduce an investor's exposure to a potential market downturn, a danger inherent in the lump-sum approach.
Pound-cost averaging also fosters a level of investing discipline. Rather than trying to figure out the best time to invest a lump sum, pound-cost averaging uses a more systematic approach that helps investors conquer bad habits such as buying shares only when the market is up.
If you have an employer-sponsored pension account, you may be using pound-cost-averaging without even knowing it. That monthly contribution made to your pension is a form of pound-cost-averaging.
Putting Pound-Cost Averaging to the Test
Despite the conventional wisdom that pound-cost averaging is usually the best way to invest, there is an opportunity-cost to be paid for holding money in cash while it waits to be invested in the market. If the market goes up while you're pound-cost averaging into it, you've lost out on any gains you would have had by investing the entire amount right away.
In fact, a recent US Vanguard study found that, on average, lump-sum investing resulted in higher returns than pound-cost averaging about two-thirds of the time. The authors looked at historical monthly returns for £1 million invested as a lump sum and through pound-cost averaging over periods as short as 6 months and as long as 36 months, assuming that funds were kept in cash before being invested. They tested various stock/bond allocations ranging from an all-equities portfolio to an all-bond portfolio. Finally, they tested these variations on the pound-cost averaging vs. lump-sum question over rolling 10-year periods from 1926-2011.
At the end of each 10-year period, the portfolio value of the lump-sum method was compared with that of the pound-cost averaging method. The result: the lump-sum method delivered higher returns compared with the 12-month pound-cost averaging method about 66% of the time regardless of whether an all-equities, all-bond, or 60% equity/40% bond allocation was used.
When the authors conducted a similar analysis using historical returns for markets in the UK and Australia, a similar pattern emerged, with lump-sum investing consistently outperforming pound-cost averaging.
The authors note that the longer the pound-cost averaging time frame, the greater the chance of the lump-sum method outperforming. For example, pound-cost averaging over 36 months lost out to the lump-sum method 90% of the time for US markets.
It's also worth noting that while lump-sum investing consistently outperformed pound-cost averaging, the average rate of outperformance was relatively modest. Using a 60/40 equity-bond allocation in US markets and pound-cost averaging over a period of 12 months, the authors found that after 10 years the initial £1 million investment would have grown to £2,450,264 on average using the lump-sum method versus £2,395,824 using pound-cost averaging, a difference of about £54,000 or 2.3%.
Pound-Cost Averaging Better in Declining Markets
The Vanguard study proves it's always best to invest in a lump sum if possible, right? Not so fast. As the authors concede, during market declines, the pound-cost averaging method often performs better because it helps mitigate the effects of falling share prices, whereas the lump-sum method puts all the capital at risk in the market at once. They examined more than 1,000 rolling 12-month periods in US markets and found that lump-sum investors would have seen their investment decline in value 22.4% of the time vs. 17.6% for pound-cost averaging.
The Takeaway
What should we make of these findings? There appears to be little doubt that, when investing for the long-term, you are more likely to end up ahead using the lump-sum approach than pound-cost averaging. (Again, assuming you have a choice--with a work-sponsored pension, you may not.) However, there are three important points in pound-cost averaging's favour.
- If you expect a market downturn in the near future, pound-cost averaging is the better choice. By spreading out contributions at regular intervals, you are essentially limiting your exposure by keeping some of your money in cash.
- For some investors, a relatively modest shortfall in return is a small price to pay for peace of mind. If pound-cost-averaging helps you sleep better at night than you would with an all-in strategy, it may be worth it.
- Pound-cost averaging, especially through an automatic contribution mechanism, offers a level of investing discipline that lump-sum investing does not. The lump-sum approach, by its nature, involves market timing, and that's a dangerous game to play, especially during times of volatility. Pound-cost averaging provides a smoother, more consistent entry into the market.
One last factor to consider is investing costs, which may provide an advantage for the lump-sum method. For example, if using pound-cost averaging requires paying multiple brokerage fees to buy shares of a stock in several lots rather than just once, this may further erode your returns as compared with the lump-sum method.
Ultimately, your comfort level with lump-sum investing and your expectations about the market's near-term direction should help you decide if it makes sense for you. But if the thought of moving a lump sum into the markets gives you a queasy feeling, that may provide the ultimate answer to your question about pound-cost averaging vs. a lump-sum payment.
This article is part of the special series, Investing with ISAs.
