Choosing whether to invest larger sums infrequently, or smaller sums frequently, may not seem like an important decision, but each approach can lead to profoundly different results.
There are two main routes into financial markets. Investors can drop in large sums in one go or they can drip feed money into the market via regular savings. Few people will have a choice in the approach they take – significant lump sums are hard to come
by – but it is worth considering the investment consequences for taking each path.
Putting smaller amounts into the market each month is an easier approach for most investors and is usually the way people make pension and ISA savings. This approach has much to recommend it: it builds a regular savings habit and saves any head-scratching
about whether it’s a good or bad moment to invest in the market. It imposes discipline and strips any emotion out of your decision-making.
Equally, if you’re just getting started, it is far less nerve-wracking to commit to a regular savings plan than putting thousands of pounds into stock markets in one go. This can help investors grow more comfortable with volatility. It also means that you
can start out at a relatively early stage with small amounts rather than waiting until you have a chunk of cash to invest, allowing you to benefit from the effects of compound growth for longer.
This is the behavioural part, but there are also sound financial reasons why regular savings can be a good idea. By investing regularly, you will be buying at a variety of prices: sometimes the market will be high and you will get fewer shares for your investment,
and sometimes it will be low and you will get more. This simple phenomenon is called ‘pound-cost averaging’.
For example, over the past six months, an investor would have committed a small amount of capital when markets were riding high on the post-pandemic boom, but would also have invested when markets sold off in response to the crisis in Ukraine. While their
initial investment would have fallen, their more recent investments would be doing better. In this way, their returns are smoothed out over time. This is a less stressful way to invest, making it easier to stay invested and benefit from ‘compound growth’ over
Compound growth is where the magic happens for long-term investors. For example, £200 invested over 10 years in a savings account paying 1% would give you a pot of £38,822. Invested at 5% - approximately the long-term annual growth of the stock market –
it would give you a pot of £53,457. This is the importance of growth on growth.
Investing a lump sum
A lump sum is a nice problem to have. However, it can be painful to lose it on a bad decision. If you put it all in the market at once, you may get lucky. You may hit the bottom of the market and make many times your money, far more than if you’d taken the
cautious approach of drip-feeding it into markets.
The problem is that investors don’t have a great track record of finding the bottom of the market. If anything, they’re more likely to be whipped up with market enthusiasm and invest at the top, just before it takes a dive. Humans like to follow the herd
– it is instinctively reassuring when lots of other investors are buying into markets at the same time. This is how bubbles such as the dot.com boom develop.
This habit of poor decision-making is borne out by various studies. The well-respected Dalbar annual investor study shows that investors consistently underperform the market
because they move in and out of markets at the wrong moment, particularly during periods of volatility.
With this in mind, hoping to find the right entry and exit point in the market could be wishful thinking.
However, if you want to do it anyway, there are a few precautionary measures. You need to make sure you are diversified – avoid speculative single stock investments unless you are willing to lose the lot. It also helps to be aware of your behavioural biases.
Have you done your homework? Or are you just caught up in the latest ‘hot’ stock?
Nevertheless, it can make sense to put capital to work in the market as quickly as possible. With inflation at long-term highs, holding cash in a bank account paying 1-2% interest is very expensive. Once your capital is invested, it has the potential for
inflation-adjusted growth, plus you can start to receive dividends.
You need to be aware of how your investment platform charges for making certain decisions. If you are saving relatively small amounts regularly, costs can become more important. If, for example, there is a high dealing charge for every trade, it can chip
away at your returns over time. You need to find an investment platform that suits the way you want to invest or has flexible pricing options.
Regular savings are usually the best option for less experienced investors. Those putting a lump sum to work should follow some basic good practice – such as ensuring diversification and ensuring they have a balanced portfolio. Whichever approach you use,
you should take care on costs.