For many individuals, receiving a lump sum is a key turning point. When markets are uncertain, as they are today, it can be difficult to know when to put the resulting cash windfall to work. Whether you sold your business, inherited a windfall, received your pension payment or maybe won the lottery, we want you to know the best strategies to invest the lump sum.
When it comes to investing, there are two ways to deposit into the account, either by investing a lump sum in one go or by drip feeding into the account with regular monthly payments. But which option is best for you? Both payment methods have their perks, and in this blog, we will compare the two so that you can decide what is best for your lump sum.
What is Pound Cost Averaging?
Pound cost averaging is the process of drip-feeding your money into an investment account regularly. In short, it is the process of setting up a monthly payment into your investment account, usually by direct debit. While it’s true that the stock market does go up over time, it’s possible that this is not one of those times. That means if the price of your chosen investment goes down but you continue to invest the same amount, you get more shares of that investment.
Benefits of Pound Cost Averaging
When choosing pound cost averaging as your chosen investment method, the share prices will vary every time you purchase. This means you may buy more shares when they’re at a lower price and sometimes when they’re at a higher price. This tends to balance and average over time – hence the name pound cost average.
When investing using pound cost averaging, you’re not timing the market, meaning investing at the ideal time when markets are down to benefit from low costs. Timing the markets is no easy job and takes a lot of research. Most leave this to the professionals (us). Pound cost averaging is, therefore, a much simpler option for inexperienced or first-time investors. This is as no knowledge of the market is needed. You essentially let your money do its thing, and you’re in it for the long game. It’s also a good option for anxious investors, as you’re not seeing a huge investment immediately fluctuate, which can cause anxiety for even the riskiest investors.
Lump sum payments
If you invest your lump sum all at once, you won’t be tempted to spend it. Money sitting in your current account has a way of disappearing. An extra splurge here, an evening out there, a mini-break… soon it’s not as much anymore, and you never got around to investing it. In addition, life gets busy, and even with the best intentions, you may not get around to investing it as regularly as you should.
Benefits of lump sum deposits
The method of lump sum investing allows you more control over your investment. It allows you to place your investment at the best time when share prices are low. This means if the share price increases, you can sell them for a potential profit.
Investing a lump sum is for those with high-risk and high-reward ambitions and is not for the faint-hearted. The risk may be worthwhile if you’re keen on getting a high reward and have money to play with. Although you should only invest with a lump sum if you are comfortable with the amount of risk involved in your investment.
Example 1 shows the Pound Cost Average method for two different clients over a volatile period.
Client A invests £1,000 a month over the year, while Client B invests £12,000 in January. The market is falling and rising throughout the year, with the unit price following the same trend.
By December, Client A could take advantage of falling prices, bought more than 1,000 more units and paid a lower average price than Client B, leaving Customer A with almost £2,000 more over the 1 year.
The solid line shows investments in the ABI Mixed Investment 20-60% shares with a payment of £24,000, while the dotted line shows regular contributions of £1,000 over the same period.
Example 2A shows a real example of how using Pound Cost Averaging through the last financial crisis in 2007 to 2009 may have been beneficial.
You can see that the Pound Cost Averaging method here has led to a higher number of total units bought, a lower paid average price and a higher final value.
Example 2B then shows a real example (using the same basis as Example 2A) of how the Pound Cost Averaging method can lead to poorer results in a market with net positive returns. Using either method (or even a mixture of both), a well-structured, long-term investment strategy should help you build enough investments to support you through retirement.
How to decide on the right approach
Evidence shows that in most cases, you’re better off investing your money as a lump sum. If your goal is to maximise expected returns, it’s the strategy for you. However, if the idea of investing it all at once gives you anxiety, and thoughts of a downturn would fill you with dread, then pound cost averaging is more suitable.
Remember… it’s best to invest in the way you feel most comfortable, than to not invest at all.
Capital at risk — the value of your investment can go down as well as up.
Ross Whatnall is CEO and co-founder of GSB and a highly experienced private client director. Ross holds many insurance and investment management qualifications, including CISI, CII, LIBF and CFA. He started his career in private banking with HSBC in the UK before moving to the UAE in 2013 to focus on serving his private clients.