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07 May 2012

Save Regularly But Don't Fear Lump Sum Investment

Investors are often confronted with the conundrum of whether to invest a single lump sum at a specific point in time, or whether to contribute a regular amount to an investment. Mario Schoeman, Client Service Manager at Foord Asset Management, shows that both strategies have merit.

Investing a lump sum involves an element of market timing. Market timing is a well-researched topic with most studies concluding that the average investor is a shocking timer of the market. Buying into an investment or asset class when it is expensive (after it has risen in price) and selling when it is cheap (after the price has declined) is an unbelievably common practice.

These studies imply that one should never invest a lump sum for fear of getting the timing wrong. The alternative strategy is one of making regular investments over a period of time, often called “rand cost averaging”. The term describes the practice of investing irrespective of whether the market is up or down – and so converging your investment to a better average price.

To answer the question of lump sum vs. regular investment, we asked Darron West of the University of Cape Town, to analyse the returns achieved when investing lump sums or equivalent regular contributions. Darron used monthly total return data for the JSE going back to January 1960 – a period exceeding 50 years. The analysis clearly showed that the longer your investment horizon, the less you need to concern yourself with market timing(1). Lump sum investing is therefore fraught with fewer dangers the longer your intended investment horizon.

The results of our analysis of a rand cost averaging strategy using past JSE returns are even more profound. Over investment horizons shorter than five years, the average return earned by a regular investor is statistically significantly higher than that earned by a lump sum investor. However, the additional benefit of investing regularly declines as the investment period approaches 20 years(2). This is consistent with the earlier observation that investors are relatively indifferent to market timing with long investment horizons. It is also consistent with the notion that price volatility should have little bearing on the perspective of a long-term investor.

We draw two clear conclusions. Firstly, regular contributions to an investment offer the prospect of somewhat higher average returns over the shorter term as advantage is taken the market’s vagaries and the associated timing benefits. This benefit reduces as the investment horizon increases. Secondly, if you have a lump sum to invest for the long term, your timing has less effect that you may initially believe, especially when investing into an actively managed and diversified general equity fund or multi-asset class fund.

  1. Over all one-year investment periods, the highest return earned is 123%, and the lowest return is -47% with an average of 21%. Stretching the investment horizon to five years, the maximum and minimum annualised returns contract to 46% and 1% respectively, while the average remains relatively constant at 18%. Over all 20-year investment horizons, the maximum annualised return is 26% per annum, the minimum is 15% per annum and the average is 19% per annum.
  2. The additional benefit of investing regularly declines from almost 6% per annum. over one-year investment horizons to just over 1% per annum over four-year investment horizons. Beyond that, the improvement in average returns amounts to just 0.5% per annum (although this increment, compounded over 20 years, results in a 10% increase in wealth at the end of the investment horizon).

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