The golden rule of investing money is that you need a strategy. This comes before choosing your markets or how much you intend to invest in each. A strategy is the overall plan that dictates what, when and how much you invest, and this tends to be influenced by your character, the amount of money you have to invest, and what access you have to that money.
You will often read about long term versus short term investing, and how these can bring differing rewards. This can be bracketed alongside investing one large amount of money or smaller investments of regular amounts in terms of importance. In investment parlance, this is known as lump sum investing versus pound cost averaging. There are many pros and cons of each method and the aim is to find the method that suits your circumstances best.
In simple terms, it is possible that investing a lump sum isn’t an option for you because you don’t have one, and you are looking only to invest what is left from your monthly salary via a direct debit. You still need to understand the potential pitfalls of this and what kind of rewards you can expect.
What is lump sum investing?
This has a very literal meaning in investment terms, but the definition of lump sum can vary according to the individual. Maybe you have saved up £250,000 over a number of years and are ready to invest it, or maybe you have been awarded a £10,000 bonus at work.
In relative terms each one is still a lump sum, and when looking at the benefits of longer term investing, the difference between investing £100 each month for a year or investing £1200 all in one go, can be quite profound. So everyone’s idea of a ‘lump sum’ can be different. The key is that you are investing for the long term.
Lump sum investment means you are investing all your savings in one go, and looking to benefit from that money having more time on the market. And this could be in stocks and shares or via pension funds, property crowdfunding or peer-to-peer lending. You can still spread your money over different investments, but essentially all your money is invested in one go and then you have to sit back and watch how it performs.
What are the advantages of lump sum investing?
There are not many certainties in the world of investment, but generally speaking, it is widely accepted that investing for the long term is the most rewarding method. Many different statistics show that investing a lump sum and leaving it to deal with the many peaks and troughs of the various markets, will net a greater return.
Lump sum investment versus pound cost averaging can be analysed over a 10, 20 or 30 year period, and investing one lump sum on day one will usually bring greater rewards, compared to investing the same amount of money split over regular monthly payments and for the same total period of time.
Most financial advisors would recommend that if you have the lump sum available, you should invest it now. Of course, the tricky part is what you invest in.
With lump sum investing, your entire investment is exposed to the market for a longer period of time, so naturally, when the market price is good you will benefit more. This of course also exposes you to the risk of market prices going down, but share prices tend to go up over the long term, and there are other less volatile investment products where a return is more stable, such as property crowdfunding or P2P lending.
You will also benefit from compound interest via lump sum investing. This means that the capital growth of your investment earns money quicker as the interest is earning money for you, as well as your initial investment gaining in value too. A final benefit of lump sum investment is that you are not liable for set-up costs or management fees, which sometimes come with switching investments and making new ones, although these can be avoided anyway with careful management and advice.
What are the disadvantages of lump sum investing?
The obvious downside to lump sum investment is that you are putting all your money at risk, so you need to choose your investment portfolio very wisely and, just as importantly, hold your nerve at crucial times. A lot of this comes down to personality as well as financial circumstances. Can you handle the regret or the stress if markets fall?
You may have chosen lump sum investment because you only want a passive involvement in your investment. This is absolutely fine, but you need to be prepared to get involved if you stand to risk losing money on a particular investment and will need to react accordingly. Or you may be happy to hold your nerve and ride it out.
What is pound cost averaging?
Pound cost averaging is the regular drip-feeding of more modest amounts of money into one or more investment markets. The ‘averaging’ term comes from the fact that you are committed to buying shares or investing in property or pension funds, at whatever price the market is currently at. Of course this can change from month-to-month, but you hope that the average price over time brings you financial benefits, which statistically it probably will.
It may be that you don’t have a lump sum to invest, but can afford to commit to £100 leftover from household bills etc each month, and you want a practical and pain-free investment vehicle through which you know where you are. This is known as pound cost averaging and it is a method that certainly works for a lot of people.
What are the advantages of pound cost averaging?
It is widely felt that pound cost averaging is a safer form of investment which presents much less worry about the inevitable peaks and troughs of the investment market. Naturally, your gains will be slower and more modest, but there is security as you are effectively protected against the market falling. Because you are not investing a lump sum, or your entire pot of money, you are only risking the small amount you have invested at the time the market falls. This also means that, in the event that the market price falls, you can start to invest money again at this lower price. In some respects, this strategy can also apply to other investment markets, particularly property.
With pound cost averaging you also have the option of taking a longer term approach, at least relatively-speaking. You can invest a regular amount annually instead of monthly, which means you are still taking advantage of the general upturn in market prices, without risking your whole lump sum. Also, you have the flexibility to increase your regular investment amounts or withdraw from a particular investment, according to how the market is going. So whilst market volatility might not be something you want to be stressed about, you do have the option to react to it if you need to.
The most fundamental advantage of pound cost averaging is that if you don’t have a lump sum saved up, you can still earn good rewards though this form of investment, even if they are not as good as through lump sum investing. But then, essentially, you won’t miss what you never had.
What are the disadvantages of pound cost averaging?
The success or otherwise of pound cost averaging hinges on the market conditions when you invest, and it can be difficult to assess when is the best time to put your money in. If you commit to a direct debit amount to invest each month, it is easy to become obsessed with your portfolio and how it is performing, and for what is classed as a ‘safe’ investment strategy, that might not be what you want.
Pound cost averaging is a smart use of money, but not if you have a lump sum stockpiled and only want to drip-feed it into investments. This means you have a pot of money that is actually losing value due to inflation, unless it is in a good savings account. But essentially, you are wasting the earning potential of this pot of money, so pound cost averaging only makes financial sense if you are investing small amounts because that is all you can afford. Any lump sum you have available should ideally be invested as soon as possible.
The obvious downside to pound cost averaging is that financial gains are slower and more modest because of the incremental investment you are making over time. Putting all your money in upfront is going to bring you quicker and bigger returns, but this all depends on what you want the money for and how quickly you want access to it. It may be that pound cost averaging suits your ambitions for the money you are managing to save.
Lump sum investing versus pound cost averaging: who are they best suited to?
A lump sum investor is somebody who can afford to ride out the inevitable volatility in investment markets and doesn’t necessarily need or want access to their money any time soon. They are a long term investor and can hold their nerve, knowing that all their savings are tied up in these investments. In some cases, lump sum investors will be people looking to save up a nice pension pot for themselves.
Typically, the lump sum investor will be more experienced, and has not only been able to hand-pick the types of investments that suit them, but has learnt to be able to hold firm when market fluctuations create a wobble. There is no substitute for experience when the stress of a dip in the market occurs, and the lump sum investor has usually seen this before.
A pound cost averaging investor is perhaps more risk averse than a lump sum investor. They are committed to a certain investment and are prepared to gamble on the market changes that take place, knowing that they only have smaller amounts of money invested.
You often find that pound cost averaging investors are first-time or novice investors, but that doesn’t mean they don’t have ambitions to be a much bolder investor as they gain experience and get used to how the markets change.
Ultimately, which type of investment strategy suits you comes down to experience and ambition, how you plan to play the investment markets and what you want out of them. At all times, you would be advised to take financial advice where you can, because market knowledge is absolutely critical.