Most of us will be familiar with the concept of regular investing, through pension saving for retirement. Each month, contributions are deducted from salary or earnings and under a Defined Contribution arrangement, are invested into a stock market fund. The monetary contribution buys a number of units based on the prevailing price of the fund on the day the contribution is received by the pension provider. At each monthly contribution point, the number of shares the contribution buys is different, as the price of the units will fluctuate from month to month.
When markets are buoyant, and performing well, the monthly contribution is likely to buy less shares, as the price of the fund is likely to be higher. Conversely, when markets are under pressure, the monthly contribution is likely to buy a greater number of shares as the price will be lower. By saving regularly and investing at different entry points, this provides the benefit of “Pound Cost Averaging”, which is an effective way of smoothing out the peaks and troughs that markets experience over a period of time.
Under a pension arrangement, or any other regular saving approach, regular savings of this manner are often the only way that an individual can effectively save over the longer term. As the regular savings are deducted from salary, this leads to a disciplined saving regime month after month. But what if the investor has a lump sum to invest? Should regular savings still be employed, or should the investment be made in a single transaction? This is a more complex decision, where a series of factors need to be considered before reaching a decision.
Don’t try and time the investment
Conventional investment wisdom would dictate that investors should maximise the time that investments are held, and therefore the simple answer would be that a rational investor would make a lump sum investment at the earliest opportunity in order for the investment to begin working for them. In periods when markets are stable or rising, this is often sound advice, as not being invested comes with an opportunity cost.
Missing out on just a few of the best performing days that investment markets have witnessed can have a dramatic impact on long term performance. For example, the annualised return achieved on an investment made in 1990, invested in the S&P500 index of US Equities, would fall from 10.4% per annum to 7.7% per annum if just the 10 best days, when markets gained the most, were missed. This is, perhaps, the best illustration of the importance of being invested in markets, and staying invested for the long term, rather than trying to time the entry point into an investment position.
A phased approach
When markets are more volatile, however, a case can be made to drip feed the investment in over a number of months. When a lump sum investment is split into a number of smaller investments that are made over a period of time, this is known as “Phasing”. A phased investment approach effectively converts the lump sum investment into a series of smaller amounts, which are then invested over a period of months. The investment is normally established so that the same amount is invested at each point in the phasing process, and as prices and values will be different from month to month, each purchase buys a different number of shares in a fund or series of funds, thus smoothing the entry into markets.
Phasing can work in an investor’s favour, if markets fall during the phasing process. At each investment point, the phased investment would buy a greater number of shares if prices are falling, leading to a better outcome than if the lump sum was invested in a single transaction. On the other hand, rising markets will mean that each phased purchase will buy less shares, if prices are rising, leading to a worse outcome than would be the case using a single purchase point.
An individual decision
Other factors need to be considered when deciding on whether to invest a lump sum immediately, or phase an investment over a series of smaller transactions. For example, investment experience is an important consideration. If an investor is making a lump sum investment for the first time, drip feeding funds in over a period of time can be helpful in reassuring a nervous investor.
The opportunity cost of not investing in a single lump sum also needs to be considered. If funds are held in cash during a phasing process, and are not invested, the cash funds are likely to earn a negligible rate of interest, and if the investor is seeking to generate income from the investments, the income stream will take longer to develop, as only a small investment would be made initially.
Lastly, the size of the investment, in relation to value of an individual’s wealth, may also be a contributory factor in the decision making process. If a large lump sum is being invested, the investor may be more keen to invest over a number of months, rather than investing in a single transaction.
Deciding on an appropriate strategy for entry into an investment position is an area where independent advice from a professional can add significant value. At FAS, we employ Phasing where appropriate and always consider an individual’s circumstances in a holistic manner when advising whether to invest a lump sum using a phased approach or not. As each individual’s needs and objectives are different, we take the time to talk to our clients about risk and volatility, enabling clients to reach a decision with which they are comfortable.
If you would like to discuss the benefits and drawbacks of phasing with one of our experienced advisers, please get in touch here.
The value of investments and the income they produce can fall as well as rise. You may get back less than you invested. Past performance is not a reliable indicator of future performance. Investing in stocks and shares should be regarded as a long term investment and should fit in with your overall attitude to risk and your financial circumstance.