Pound-cost-averaging—the notion of moving money into securities slowly over time rather than all at once—is close to dogma in financial-planning circles.
But when you look closely at the data, pound-cost averaging doesn't compare favourably with the strategy of investing a lump sum and letting it ride. The simple reason, as discussed in a Vanguard research paper and by my colleague Adam Zoll in his article ‘Is Pound-Cost Averaging Overrated?’, is that stocks generally trend upwards over time. Given that, you're generally better off investing the largest amount you can as soon as you can rather than dribbling the money into the market slowly during a period of months and years.
Yet as well-grounded as that research is, I'd argue that pound-cost averaging is still a sound strategy for most investors, mainly because of the following logistical and behavioural factors that accompany the two approaches.
Most People Don't Have Lump Sums
At the most basic level, most people simply don't have lump sums to invest, and if they do, it's a good bet they amassed a lump sum by holding off on investing it in the market or by pulling out funds that were once invested in long-term assets. Such manoeuvres run counter to the research in support of lump-sum investing.
One of the reasons that pound-cost averaging has picked up traction in financial-planning circles is that most of us earn our money in dribs and drabs, so it's only natural to deploy it in a piecemeal way, too. That way we don't disrupt our standards of living too much at any one point in time. For most households, it's much easier to budget for a £940 monthly contribution to an ISA in order to hit the £11,280 annual allowance rather than to come up with £11,280 in April of each year. The same goes for pension plans and any other pre-set savings plan.
Of course, it's true that some people come into lump sums of money not because they've saved it but because they've got a bonus, inherited the money, or opted for a lump-sum pension payment. That's a best-case scenario for lump-sum investing, enabling an investor to take advantage of the upward long-term trend in market movements without disrupting household cash flow.
At the same time, it's worth noting that people frequently inherit money and certainly receive lump-sum pension payments later in life, when they may not have the luxury of time for lump-sum investing to be the better option. Were the lump sum to be invested at a particularly inopportune time, such as mid-2008, the investor would need to have a reasonably long time horizon for the lump-sum purchase to achieve better results than a pound-cost averaging strategy employed during the same time frame. The data in support of lump-sum investing demonstrate that the longer one's time horizon, the greater the probability of long-term success with the lump-sum strategy relative to pound-cost averaging, though Vanguard's study showed that lump-sum investing beat pound-cost averaging in 90% of three-year time horizons in the United States.
Psychological Impediments
An equally important factor is that pound-cost averaging can help investors overcome some of the psychological impediments that can bedevil investors, especially the difficulty of staying disciplined with their investment programmes in tough markets.
Say, for example, you had the financial wherewithal to make your full £11,280 ISA contribution at the beginning of the 2012-2013 tax year, rather than spacing out your contributions throughout the year; your goal is to harness the extra compounding that can accompany lump-sum investments. Concentrating your investments into larger, less-frequent purchases also has the net effect of raising the stakes. Were the market to drop 25% after your single April purchase, you might be less inclined to make a purchase the following April—a decision behavioural-finance experts call "loss aversion." By contrast, the ISA investor who's spreading purchases throughout the year, as most of us do, will have only invested £940 in April, just a fraction of the planned annual contribution amount. If the market supplies decent performance in some months to help offset the sharp January losses, the investor might be less inclined to give up on future investments. Behavioural-finance expert and Santa Clara University professor Meir Statman explored the psychological case for spreading investments in his research paper ‘A Behavioural Framework for Dollar-Cost Averaging.’
A Valuable Tool in Frothy (or Worse) Markets
Finally, even for investors who are sold on the research supporting lump-sum investing, pound-cost averaging can prove a valuable tool in declining markets, as discussed in the aforementioned Vanguard study. That's because the pound-cost-averaging investor can take greater advantage of falling share prices than the one who invests a lump sum, only to watch the markets fall further still.
By extension, pound-cost averaging can also be an effective strategy if the fundamentals of an asset class point to it being overvalued, helping the investor avoid putting a lot of money to work at what in hindsight was an inopportune time. That's arguably the case with fixed-income markets today, with yields on many bond assets seemingly as low as they can go. For baby boomers who know they need more bond exposure in their portfolios but are concerned about investing in the asset class at the wrong time, a suitable strategy could be to de-risk the portfolio immediately, then gradually pound-cost average into bonds in the months and years ahead.
This article is part of the special series, Investing with ISAs.
