Buy Now or Wait?
Key Takeaways
Waiting to enter the market will result in opportunity costs, which can add up to a lot of lost investment returns.
A lump sum investment is historically and statistically proven to grow wealth better than phasing in over time via a cost averaging methodology.
However, humans are behavioural beings and tend to rely on emotional decision making. As such, investors may prefer not to maximise their investment output and may want to cost averaging as it “feels better.”
All things considered, which strategy ends up with the largest return really depends on the individual and their temperament - working with an advisor on an appropriate plan will help you decide which option is the best for you.
The best time to plant a tree is 20 years ago. The second best time is now.
— Chinese Proverb
Imagine receiving a large sum of cash due to an inheritance, bonus payment, or sale of a small business. How would you invest it? You may just be starting out in investing — should you put it all in at once? What if the market tanks the very next day? You would certainly feel pretty badly about your decision. Sometimes this fear ends up leaving us paralysed to act.
This is an important but common question asked by many investors. Research shows that a lump sum investment (LS) outpaces a series of investments over time — also known as cost averaging (CA) — two thirds of the time according to historical and simulated market data.
Using about half a century of MSCI World Index returns (1976–2022), the data shows that LS outperformed CA 68% of the time across global markets measured after one year. However, CA was certainly better than doing nothing at all — outperforming cash 69% of the time.
The Fear of Immediate ‘Failure’
One of the reasons that investors are worried about lump sum investing is the fear of a loss or dip shortly after putting that money to work. It is worth noting then that researchers also included the outcome of a $100,000 investment after a one-year investment period in their parameters. A lump sum investment outperforms all other options except for the worst periods (at the bottom 5th percentile) — which is logical because if the market is collapsing then averaging in would give better results. However, this only works for more aggressive portfolio allocations (higher equity) and by virtue of it being the bottom percentiles, it does not happen often.
In addition to historical data, 10,000 simulated-return scenarios were used to compare LS with CA. Consistent with findings from the historical analysis, LS in most cases yielded greater wealth after one year, but also greater losses in some of the worst market environments.
The chart below shows that LS (teal line) grew wealth better but also lost more when markets did worse (returns at the bottom 5th percentile).
Although the evidence is clear, we are aware that not every investor may want to maximise their returns. Why? It is due to an inherent human behavioural bias called loss aversion, something that Nobel laureates Daniel Kahneman and Richard Thaler has written about.
As such, conservative investors can consider the CA strategy because of its lower risk (albeit temporarily) despite the lower returns. However, if the CA strategy helps someone sit through a particularly turbulent time in financial markets, then it would have done its job as a successful strategy.
So does a LS or CA strategy work better for you? It will be useful for you to determine this working with a fiduciary advisor in devising a thorough and comprehensive plan. The advisor would be able to point out the pros and cons in each strategy for you, and also help you lay out all the evidence in order for you to make the best decision.
If you would like to find out more about how to properly allocate or invest properly during different market conditions and the process we adopt, come and have a chat with us.
