Is it better to invest in lump sums or monthly?

A question I am often asked is “is it better to invest in lump sums or monthly by direct debit” and the answer I give is always the same…’it depends on what the markets do after you’ve invested’.  OK, it sounds like a cop out but let me explain…

When you invest in a lump sum the whole amount is then at the whim of what the unit price of your investment does.  So if you invest £10,000 in a fund and the unit price is £1 then you will buy 10,000 units.  If, in the following month, the unit price increases to £1.01 that means your £10,000 is now worth £10,100.  If the fund had dropped by 1% then the unit price will be 99p and your investment will be worth £9900.  So, once invested, the success or demise of your fund is fully exposed to the gains or falls of the unit price.

Now let’s say that, instead of investing £10,000 as a lump sum, you chose to invest £1000 per month.  Your first debit will therefore purchase 1000 units at £1 and will be worth £1000.  Assuming the same market conditions as above then the 1% rise in the following month means that your first investment will now be worth £1010 BUT – and this is the essence of pound cost averaging - your second investment of £1000 will now be buying units valued at £1.10, which means your £1000 direct debit will only buy 909 units (909x 1.10 = 1000).*

So in this example your £10,000 lump sum investment will have made a 1% gain after 1 month but your 2 monthly contributions will only have made a gain of  0.95% - because you will have bought 1909 units valued at £1.10 which is £2099.90.

So, if markets are going to rise more than they fall then investing as a lump sum would give you a better return.

Now lets look at a market fall and a unit price reduction of 1%.  Your £10,000 lump sum would be worth £9900 and your 1st months direct debit would be worth £990 but now your 2nd months direct debit will be buying units at 99p.  This means you will buy 1010 units in your second month.  So after month 1 your £10,000 has lost 1% but your monthly contributions have only lost 0.5% (2010 units x .99p = £1989.90 which is 99.5% of £2000).

So, if markets fall more than they rise then investing monthly would give you a better return.

Obviously in the examples above the differences are marginal but if you compound this over time they can make a significant difference to the value of your investment.

In the image below you can see an example of how the units you buy increase when markets fall and vice versa.

So simply put, pound cost averaging allows savers to soften the blow from market falls by investing a small amount regularly as it allows them to buy units more cheaply on average.  However, in rising markets investing a lump sum will always triumph over monthly contributions.

Of course, not all investors have the choice of choosing a lump sum as they don’t have the funds available.  However, a couple who are fortunate enough to be able to maximise their pension and ISA allowances can’t go far wrong by choosing both strategies.  One could invest a lump sum and the other could invest monthly.  At least this way you can edge your bets and benefit from both sides of the coin.

Brian