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Should you invest a large amount of cash all at once, or “drip feed” it into a portfolio gradually? The former is often called lump sum investing; the latter, pound-cost averaging (or “dollar-cost averaging” if you deal mainly in USD). What are the benefits and drawbacks of each option?
Below, we compare the two approaches from the standpoint of an early-stage investor in the UK. We hope these insights are helpful. To learn more about our EIS projects and other early-stage opportunities, visit our portfolio page. For enquiries regarding our latest projects and funding, you can reach us via:
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Lump sum investing
Suppose you sell your equity stake in a startup business after reaching your exit strategy goals. What now? The proceeds could be immediately re-invested into another promising startup. Alternatively, the money could be ploughed into a range of companies, funds and assets to “spread out” the risk.
In the long term, a lump sum investment could offer higher potential returns compared to pound-cost investing. This is because your money is “put to work” earlier, allowing it to benefit more from the power of compound interest.
By contrast, a drip-feed approach temporarily leaves some of the cash in the bank, earning interest at a lower rate than the returns that could be achieved from other investments, thus incurring an opportunity cost).
There is also the benefit of lower transaction costs. Pound-cost averaging involves making multiple trades (e.g. monthly). Each trade might involve paying various fees (e.g. spreads or commissions), which eat into your potential returns. By contrast, a lump sum approach confines these costs to a single transaction.
However, there are downsides to consider. Notably, investing a lump sum exposes an investor fully to volatility in the stock market. This can cause great psychological stress as investors experience anxiety about short-term fluctuations. The urge towards loss aversion can be especially acute if the market crashes shortly after a lump sum investment.
This is sometimes called “timing risk”. To maximise returns from a lump sum investment into equities, the investor needs perfect information about market conditions and trends – allowing them to “time” their investment accurately. However, this is very difficult (if not impossible).
Pound-cost averaging
Many of the benefits and drawbacks of pound-cost averaging (PCA) are the opposite of lump sum investing. One key advantage is that PCA mitigates timing risk by spreading out portfolio contributions over many months. When volatility occurs, the investor sometimes buys at a higher price and sometimes at a lower price.
A valuable by-product of this approach is financial discipline. By investing regularly, investors build a habit of saving and investing rather than simply spending income and wealth immediately on consumer goods.
It also teaches investors to regard “low points” in the market as buying opportunities. For example, when the prices of valuable companies are down, this could be a great chance to buy equity stakes at a “discount.” Capitalising on market dips, rather than viewing them purely in negative terms, can help investors enjoy greater returns in the long run.
However, PCA can have a significant opportunity cost. Transaction costs can be higher, and returns may take longer to appear compared to a lump-sum approach. Moreover, PCA does not eliminate investor anxiety, especially if the contributions occur during a volatile period in markets (e.g. over many months or 2+ years).
Investing new-found cash as an early-stage investor
Many private investors gravitate towards PCA due to their financial circumstances. Bluntly, if have less money in savings, you are less likely to want to risk it by immediately committing a sudden windfall (e.g. £10,000) to volatile investments.
However, early-stage investors are often in a different position. Angel investors, for instance, typically invest sums ranging from £5,000 to £500,000 into a single startup. Their asset base allows for more risk-taking compared to, say, an employee at a supermarket who suddenly receives a generous inheritance from a loved one who just passed.
With this said, angel investors cannot afford to be reckless. Indeed, the higher risk often involved with early-stage businesses requires careful due diligence before committing funds. Private investors often have little choice but to adopt PCA due to their income levels (e.g. pension contributions are taken out of their paycheque). Angel investors, by contrast, may be exiting multiple startup investments each year – releasing large profits each time, which then need to be considered thoughtfully.
Several factors need to be considered when dealing with lump sum investing. These include the investor’s risk tolerance, financial goals, investment horizon and tax position. The wider economic and financial landscape also needs to be taken into account.
For instance, if interest rates are currently high, the opportunity cost of “parking” some of an investor’s money in cash-based investments (e.g. money market funds) may be lower than other periods when rates are lower. This could make PCA temporarily more attractive.
From a tax perspective, if an investor has used up his/her Personal Savings Allowance for the tax year (£1,000 for the Basic Rate and £500 for the Higher Rate), then other non-cash investments may be more tax-efficient options for committing a recent windfall – whether gradually or as a lump sum.
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