Drip feed or all in? The best way to invest

Important information - the value of investments and the income from them can go down as well as up, so you may get back less than you invest.

But here’s the catch: in January 2009, nobody knew that a sustained bull run was coming. The world was still reeling from the financial crash. And if markets had continued to tumble, lump sum investors could have suffered a nasty case of buyer’s remorse.

Investing in a bear market

This is because steadily falling markets favour drip feeders over lump sum investors. To understand this, simply take our earlier example and reverse the logic. If you invest everything upfront, you invest all your money when markets are expensive compared with the future.

In contrast, if you drip feed your money into the market, you encounter falling prices, meaning you get more units for your money as time goes by. You also have a smoother ride with fewer stomach-lurching moments.

This played out to interesting effect during the dot-com crash.

Investing in the real world

So that’s the theory. In the real world, however, we encounter a couple of problems. First, no one knows for certain which way markets are heading. Second, markets have an annoying habit of moving up and down, particularly over short periods of time. So how do you decide which approach to take?

History is helpful here.

Back in 2012, analysts at Vanguard dived into decades worth of data. They studied what would have happened if you had invested $1m upfront and left it for a decade. They then compared the result with the outcome of phasing $1m into the market over the course of a year and remaining invested for the rest of the decade¹.

They found that a lump sum approach outperformed drip feeding approximately two thirds of the time. And, when you think about it, this makes sense: markets tend to rise more than they fall - otherwise no one would invest at all.

Likelihood of outperformance, based on history

^{Source: Vanguard, 2012. Based on relative probability of outperformance of lump sum investing versus 12-month drip feed into the US market.}

The report contains some other important findings, however, relating to risk.

“Risk-averse investors may be less concerned about averages than they are about worst-case scenarios, as well as the potential feelings of regret that would occur if a lump-sum investment were made immediately prior to a market decline,” Vanguard said.

The firm concluded that phased investment may be a “better alternative” for investors worried about regret and short-term downside risk.

The numbers bear this out. Of the 1,021 year-long investment periods Vanguard analysed for US markets, lump sum investors would have seen their portfolios decline in value during 229 periods. Drip feeders would have experienced such declines in only 180 periods. Meanwhile, the average loss during those periods was $84,001 for lump sum investors, versus $56,947 for drip-feeders.

Conclusion

Sometimes simple questions have complicated answers - and this is one such question.

Lump sum investing and drip feeding both come with risks and rewards. But one factor looms even larger than mathematical calculations: your temperament. If you’re haunted by thoughts of buyer’s remorse and worse case scenarios, lump sum investing may not be for you. There is always a possibility that the stock market will drop shortly after you buy in.

If you have a more relaxed outlook, however - for whatever reason that may be - there are plenty of good reasons to make the leap and opt for the lump sum approach.

Source:

¹ Vanguard research July 2012

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