Is lump sum investing better than drip feeding into the stock market?

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Is lump sum investing better than drip-feeding into the stock market?

It is a common practice for investors to regularly invest smaller amounts into an investment in order to help protect them against stock market volatility. This is because you get an aggregated pricing of the market over the term of the investment.

But is this always better than investing a lump sum over the same period…

Some recent research suggests that, even if you get very unlucky and invest a lump sum into the stock market on the eve of a big crash, you could end up with bigger returns than by drip-feeding. This is because 100% is invested from day 1 whereas, in drip-feeding, the last contribution will have substantially less time invested than the first contribution.

The two key factors are the effect of compounding interest from day 1 on the invested amount as well as how long you are invested in the market. As the cliché goes, it’s not about timing the market but time in the market.

One of the golden rules of investing is to buy low and sell high. This however is much easier said than done by a retail investors. It involves constant monitoring of local and global markets, understanding how those markets operate and reading the market well enough to know when to buy and when to sell. In theory, it sounds simple. When certain stocks drop, buy them and when the rise in value, sell them. The truth of the matter is most people react exactly in the opposite way. In a bear market, when stock prices fall, many people have a knee-jerk reaction and sell off their stocks for fear of losing more of their wealth. Similarly, many people in a bull market hold on to stocks for too long out of greed for a better return and then lose the opportunity to maximize their return.

A further factor to the above is the herd mentality and investors’ probability to be influenced and follow the market noise i.e. tech in 2020. If you are following the “herd”, you’ve probably missed the opportunity.

The fact that your average investor does not have enough in-depth knowledge of all local and global markets and stocks (nor has the time to actively monitor the stocks to find the optimal buy and sell price) is the leading reason supporting a drip-feeding investment strategy. An example of this would be that of monthly savings. In this case, an investor who invests a fixed amount every month, meaning if stock prices are high, his fixed amount would buy fewer stocks and if stock prices fall, he would purchase more stocks. This way he gets an aggregate price over the term. These effects smooth out volatility and leave the investor less vulnerable to big corrections.

However, a recent study suggests that this wisdom is worth questioning. Even if your timing is terrible, it shows a lump sum will beat drip-feeding, as long as you are in for the long term. This is because the full value of your investment is exposed to compound interest from the first day. Over a long period of time, this can grow your investment exponentially. It was Einstein who referred to compounding interest as the eighth world wonder and said,” Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pay it.”

This is best illustrated as per the case study examples below:

A monthly $50 put into the average investment company from the eve of the financial crisis in October 2007 to March 2020 would by the end of March 2020 have been worth $12,319. That’s a total 63 percent return.

However, a lump sum of $7,550 ($50 multiplied by the term of 151 months) invested at the same starting point – right before the credit crunch crash, which led to losses of 41 percent for the average investment company by February 2009 – would now be worth $15,971.

That’s a substantially higher return of 112 percent, even though the lump sum was very badly timed.

Going further back to the dot-com bust the effect is more pronounced. If you had started to invest $50 a month in the average investment company from March 2000 to March 2020, it would have grown to $32,285 today from a total of $12,100 invested.

But a lump sum of $12,100 invested in March 2000 would by March this year have been worth $44,346. That’s a gain of 267 percent versus 167 percent for drip-feed.

It must be noted that the key factors in these models, as mentioned above, is the timeframe of the investment. The market research conducted, supported by the case studies, tends to support that, over substantially longer periods, a lump sum investment will generally outperform a drip-feeding investment strategy. This is also provided that the investor remains invested over the full period without making amendments to the portfolio.

However, over shorter-term periods, a drip-feeding strategy will generally outperform a lump sum investment. This is because of the aggregated pricing and is mainly due to the fact that drip feeding cushions the blow over the short period. A lump sum investment does not have the time to recover over a short-term period.

Whilst there’s no telling how long the Covid-19 emergency and current apprehensions in the market will continue, we can always look back at previous crashes and implement the best possible strategy applicable to the investment term.

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Blog published by Mike Coady.

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