The stumbling block for many investors is the starting point. Many never get over the first hurdle which is to have money in the market.
Those that make the leap of faith, which is something everyone should do, then have to decide between lump sum investing versus a recurring premium investment.
The truth is that it’s often a trade-off most investors are not able to make. The reason we say this is because we have cash flow constraints which make it difficult to accumulate large enough lump sum assets.
Therefore, recurring investing is the only option. This is not entirely true because one could accumulate cash over time and then deploy lump sums.
The Pros and Cons
Let us look into the mechanics. The reality is that accumulating cash is difficult for most people. The temptation to spend money is real.
The other thing is that even if you were disciplined enough to save your cash and avoided the temptation of spending, you would generally underperform the equity market as the return of cash relative to equities is notably lower throughout almost every investment cycle in history. So, sitting on the side-lines is essentially a sure way to underperform the market most of the time.
There are certainly some positives to recurring investments. The benefits of rand cost averaging.
In a nutshell, when investing you are purchasing an asset or set of assets. Over time equity prices are expected to rise.
However, they do not do so in a linear or smooth fashion. They move wildly over the short term but tend to trend upward over full investment cycles.
When the prices are very volatile, investors with recurring investments are purchasing a small amount of equities/units every month. The price at which they purchase these equities/units will differ depending on the market price. So essentially over a year you get a basket of the same equities for which you paid a combination of prices, therefore your total base cost is the weighted average cost of the underlying assets you purchased.
This is essentially the issue at hand, does rand cost averaging lead to outperformance or underperformance relative to lump sum investing? Remember that lump sum investors purchase all their units/equities at day one and then look at their return at the end of the period, which is the difference between the market value and the initial cost.
In our research we looked at the time period between 31 December 1992 and 28 November 2014. We compared a R12 000 lump sum investment to a 12 x R1 000 recurring investment in a JSE Equity Portfolio/Index. We did this over a few different rolling periods to check if the results were consistent.
The answer was interesting but not surprising. In the periods we looked at, lump sum investors outperformed recurring investors about 65% of the time. This differs from rolling period to rolling period, but 65% of the time if you invested a lump sum you were better off
Lump Sums Outperform
We did a more practical example as well. We took the monthly All Share Index data from the last ten years. Again the comparison was between R1 000 invested every month for the entire period. This equals a total contribution of R120 000 over the period.
We then compare this to the return that would have been generated by investing R12 000 at the beginning of every year for the same ten year period. Again the total would have been R120 000. This test was then performed over a few ten year periods. The investor who invested R12 000 per annum as a lump sum outperformed the recurring investor over almost all the ten year periods analysed.
This test was done over 27 ten year periods, the lump sum investor was better off on 24 of the periods, which is a lot higher than the result of 65% which we calculated earlier.
This leads one to believe that the longer the period analysed, the more likely the lump sum investor is to outperform. However this may be a function of the data set we looked at and if we were to do the same analysis in more than one country we may get a different answer.
The reality of the situation may be a function of the timeframe we are considering.
RSA equities have had an annualised gross return over that period of around 18,2% per annum with very few long periods of negative returns.
What this means is that it would make sense that most of the time, lump sum investors have outperformed relative to their recurring counterparts who have been continually buying equities at higher prices over the period.
What we found interesting was common periods of outperformance for recurring investments. These were generally when markets were in a downward trajectory, such as 1994/1995, 2001 when the technology crash occurred, and 2008 during the global financial crisis.
Many of these periods did not last long and very soon after prices plummeted lump sum investors were again better off.
To conclude, let us look at current valuation levels. By historical standards the local equity prices are at overpriced levels. That said, the global equity market keeps pushing to higher levels. If some market analysts are correct we should see a correction at some point. If the said correction were to occur it is likely that recurring investors would outperform their lump sum counterparts for a period of time.
Both ways of investing can be justified and recurring investors may be saying that this is the time to purchase assets at a weighted average cost level to avoid large capital losses, but the stats tell us a different story.
If you have a lump sum, then deliberately phasing it into the market actually costs you money at least 65% of the time. So dive in and get to your desired asset mix sooner rather than later.