During discussions with new clients, one question which almost always comes up is "should we put the money in all at once, or spread it out over time?"
If the question is instead "is it best to put it all in at once?", the answer would be yes. Strictly speaking, you can expect better returns by investing a lump sum.
But "should we" requires more thought, because each investor has their own unique circumstances, investment experience and attitude to risk.
Drip-feeding into an investment is known as "dollar-cost averaging", as the average cost of the shares you buy decreases over time. Going all in at the start is known as "lump-sum investing".
Why are lump-sums technically better?
A very common phrase thrown about by advisers is "it is time in the market, not timing the market". Two things to remember about share markets:
They go up more often than they go down;
Nobody knows beforehand what they will do today, next week or next month.
With this information, we should assume everyday will bring positive returns. Therefore, by investing a lump-sum as soon as possible you maximise the time invested and get the highest expected return.
Why this may not be best for you
By investing all at once, you should expect a higher return on average. However, there is the possibility markets go down right after you invest.
Spreading your investment over time lowers the average return you should expect, but reduces the range of possible outcomes. You will be reducing some downside risk while missing some of the potential (and more probable) upside.
Foregoing higher expected returns for less uncertainty is a favourable exchange for many investors. Which decision is right for you will depend on your attitude to risk.
Psychological factors
Mary Holm has covered dollar-cost averaging frequently, usually in response to investors sitting on the sidelines. In an article from August 2018 she described two important psychological factors keeping many investors in cash.
“The first is that if someone is going to invest a large sum all at once, they will probably worry that the market will fall soon afterwards. That fear can keep people on the sidelines — in a bank account — for months, whereas if they had drip-fed the money they would probably get on with it.
The second psychological point is that lots of research shows that most people want to avoid investment losses more than they want to make gains. Let’s say there’s a choice between:
An investment that will do well most of the time, but there’s a fairly big chance it will do badly.
An investment that will bring in middling returns over all, and usually do somewhat worse than the first option.
Many people will choose the second one. To see how people dislike volatility and uncertainty, just look at all the money New Zealanders hold in bank term deposits.”
If you find yourself more concerned with potential losses than missing out on gains, dollar-cost averaging is probably better for you. This can also add discipline to how you enter the market, as long as you stick with your plan whether markets go up or down.
The difference may be small
A study by Vanguard found lump-sum investing beats dollar-cost averaging about 60% of the time, if you were buying in over a 6-month period. This increases to 92% of the time over 36-months.
As long as you don't stretch your payments out for too long, the reduction in expected returns likely won't be too large. Over 10-years, that Vanguard study found lump-sum investors ahead by between 1.5% - 2.5%, depending on the country.
2% is nothing to be sneezed at, especially with a large investment. Over ten years however, this trade-off isn't very large if it gives you a more comfortable investment experience.
Time-frames for dollar-cost averaging
As mentioned above, a lump-sum investment is almost always better than averaging in over three years. So, assuming we have decided to dollar-cost average, over how many periods should we split our deposits?
The more frequent the better, so monthly or even weekly deposits are favourable. This is because you will be buying in to the market at a wider range of prices, creating a narrower range of outcomes. Thankfully internet banking allows for automatic payments, making this option easy for investors.
As for the overall time-frame, this again depends on your attitude to risk and aversion to losses. The longer the time-frame, the longer much of your money earns a pittance in the bank.
We typically wouldn't recommend more than a year before you are fully invested. For an inexperienced investor, anxious about the market, taking a year or longer to get invested is still better than sitting in cash.
For most, six-months is a good time-frame over which to dollar-cost average. The compromise between expected returns and downside-risk is quite balanced over this amount of time.
Situational factors
When deciding whether to dollar-cost average or invest all at once, you should consider your financial position as well.
If you have a large amount of cash to invest, the decision is an important one. Maybe you have sold a house or received an inheritance. In this case, give thought to the pros and cons described above.
For those who are still working, the act of saving over time gives the same benefits as dollar-cost averaging. If your initial investment is relatively small compared to the amount you will invest in time, investing all at once is fine.
If you are moving between similar investments, such as changing between two share funds, doing so over time doesn't really benefit you. Both options are already exposed to similar risks, so moving bit by bit won't help.
The verdict
While investing all at once gives the highest expected return, for many investors, trickling money in is still a better idea. This can help nervous investors get into the market when they otherwise wouldn't.
The difference between the options won't make or break your long-term plans, so don't lose sleep over it. Instead, choose an option that works for you and stick with it. If you decide to go with dollar-cost averaging, choose a sensible time-frame and make deposits regularly.