Today’s stock market volatility has given extra urgency to one of the classic questions that every investor faces at some point.
Should you invest lump sums in the stock market whenever you have cash at hand, or set up a regular monthly savings account and drip feed the money instead?
Both have advantages and, inevitably, disadvantages, too. The decision partly depends on personal factors such as your attitude to risk, how much money you have at your disposal and market conditions at the time.
The appeal of investing a lump sum is that your money starts earning right away. Given that stock markets go up over time, the sooner you invest, the better.
Dino Ibric, vice director at Swissquote Middle East and Africa, says for those looking to generate maximum returns, lump sums beat regular monthly investments.
“When markets are rising, investing a lump sum means you take full advantage today.”
If you are investing in stocks that pay dividends, it also means you will generate income sooner rather than later.
Here is how that works. Say you invested a $100,000 lump sum into a global stock market tracker and it delivered an average total return of 6 per cent a year after charges. After 25 years, you would have $429,187.
If you invested your $100,000 over 25 years instead, putting away $4,000 a year, you would end up with $249,793. That is $179,394 less. The sum is much lower because most of your $100,000 is sitting on the sidelines in the early years. The last $4,000 you invest has a mere 12 months to grow.
That is the general principle. The practice is a bit more complicated. For example, anybody who put $100,000 into shares in February last year would have been sweating when stock markets crashed in March.
They could easily have found themselves down $35,000 within days, and nobody wants to go through that.
Although they should have since recovered most of their losses and should end up well ahead after 20 or 30 years, it would not have been much fun.
Many fear that markets are vulnerable to another crash right now as Covid-19 lockdowns drag on and last year’s fiscal and monetary stimulus threatens to revive inflation. The recent sell-off in US technology stocks reflects concerns that interest rates hikes could curb growth.
Mr Ibric says drip-feeding money into the market will reassure risk-averse investors worried about investing at today’s record highs.
“It minimises the downside risk of a sinking stock market.”
A good option for those with larger sums, such as $100,000, would be to pay chunks into the market over the next six to 12 months, rather than 25 years.
That would protect you against a sudden crash – at least this year – while giving your money early exposure to the market.
Mr Ibris says you can further reduce risk by spreading your lump sum across different assets such as shares, bonds, cash and property, across several sectors and parts of the world.
“These assets should match your own personal circumstances, attitude to risk and how long you have to invest.”
In turbulent times, regular monthly investing offers one great advantage that you do not find with a lump sum.
You benefit from stock market dips as your monthly contribution will pick up more stock or investment fund units.
This process is known as dollar-cost averaging and Laith Khalaf, financial analyst at AJ Bell, says this gives you a smoother journey.
“It also takes the emotion out of investing. After you set up your monthly plan, you can more or less forget about it.”
Darius McDermott, managing director of Chelsea Financial Services, says if you invest monthly, remember to increase your contributions every year, in line with any salary increases, otherwise inflation will erode their value in real terms.
Somebody who invested $1,000 a month would have $697,877 after 25 years, assuming the same 6 per cent growth rate. However, if they increased their contributions by 3 per cent every year, they would have $931,991. That is $234,114 more.
“If your income falls at some point, you can always reduce your payments,” says Mr McDermott.
That kind of flexibility is vital. What you must not do is lock yourself into a regular monthly savings plan for a fixed term, such as 10 or 25 years, with punitive redemption penalties if you exit early.
You do not know what your income will be in future and need absolute freedom to change your mind.
While these types of contracts are less common than before, they still exist. Most are sold by offshore financial advisers and wealth managers and are aimed at unsuspecting expatriate investors.
Chris Keeling, chartered financial planner at The Fry Group, says investing regularly means you automatically avoid the temptation to time your entry into the market, something nobody can do with consistent success.
He says you should not try to time lump-sum investments either. If you pay a chunk of money into the market and it does crash, stay calm. Investors who panicked and sold last March would have banked a substantial loss.
“Those who weathered the storm were still able to make healthy returns in 2020,” Mr Keeling says.
He says investing for retirement is a long-term task, which gives you plenty of time to recover from setbacks.
“Time spent sitting on the sidelines is more detrimental to investment returns than market volatility.”
There is never a wrong time to invest, as long as you have the time to ride out market volatility, Mr Keeling says.
“Investing lump sums in rising markets and regular savings in falling markets is a good way to minimise volatility and maximise your overall investment returns.”
He also suggests taking financial advice from a qualified professional before making your investment decisions.
In practice, most people do not have much say in the matter. They invest every month because that is when their salary comes in. If you also pay in lump sums when you have money at hand, you might combine the best of both worlds. It is not often that happens in investing.