Lump sum vs cost-average investing

PUBLISHED: Tue, 16 Feb 2021 12:06:43 GMT

This article is part of an ongoing series of basic financial education brought to you by financial industry professionals curated by PocketFin – The Financial School of Real LifeCNBC Africa provides content from PocketFin as a service to its readers but does not edit the articles it publishes. CNBC Africa is not responsible for the content provided by PocketFin.

An incredibly popular topic when it comes to investing is the differentiation or option to invest with lump sums at a particular point in the market or invest monthly and make use of the idea of a “cost-average” over an extended amount of time. In this article PocketFin CEO , Pierre Van der Merwe explains the difference between a lump sum investment and a monthly investment and lends his opinion on what works best for wealth creation over the long run.

Photo by Austin Distel on Unsplash

A lump sum investment is a single contribution investment which enters the market at a specific date and at that specific price in the market. Lump sum investing is often not possible for everyone as most people are building wealth via monthly savings using their disposable income, but if for example a cash lump sum was received from the sale of an asset or an inheritance this would give you the option to invest from a lump sum perspective. 

A lump sum investment can work well in times of a major market downturn, in various “market crashes” over the past have we seen people benefit from “buying at the bottom” and therefore making a larger capital gain. Although there is a very prevalent saying in personal financial planning which is “it’s not about timing the market, but time spent in the market” , many have used the opportunity of market crashes to their advantage. 

A more achievable and popular method of investing for the long term is to make use of “cost-averaging” , and what this means is disciplined monthly contributions over a long period of time regardless of what state the market is in, by doing so you are buying “units” or “shares” at different prices resulting in an average price over the long run. 

“When most people start to panic when there is a market downturn, this is actually the absolute best time for you to have monthly amounts buying units” says Van der Merwe. This long term investment strategy involves spreading your contributions over many months and many years. 

Cost averaging can also help you deal with the turbulent markets where if you had perhaps placed a lump sum and the market crashed by say 30%, it would not affect you so badly at least from an appearance point of view. While cost averaging helps mitigate the risk if the market collapses it could also minimise potential reward. Therefore cost averaging is not a strategy to maximize an investment return but it is generally deemed safer and more manageable than a lump sum investment.

In an ideal world to really maximise the potential of your long term wealth creation, a disciplined plan involving a budget with allocated savings towards short, medium and long term investments is extremely important, if you are in the position to invest lump sums throughout your life it may be an option to “phase in” over time, perhaps releasing 25% of the lump sum every quarter, or if an opportunities arises and the market crashes, it could be your opportunity to pick up some cheap units that can benefit you at the finish line.

We hope that you enjoyed this article on the concept of lump sum investing and cost-average investing!

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