Regular vs Lump Sum investing

When talking about asset allocation, I mentioned that your strategy will need to be different depending on whether you are investing a small amount on a regular basis, or a lump sum at one time.

I would consider these two different types of money. Regular comes from your surplus over expenditure every month. It doesn’t drain your bank account. In fact, the maximum you should contribute to long term regular investments every month should be 50% of your monthly surplus. That way you don’t suddenly find yourself with cash flow trouble when a big bill comes in. Lump sum is money over and above your emergency cash reserve that you have accumulated in the bank. When you look at your asset weighting and find that you are overweight in cash, you might decide to make a lump sum investment into medium term assets in order to correct the overall weighting.

Now if you are going to invest $50,000 tomorrow, you will probably want to be very careful about your asset allocation, particularly if you have a low appetite for risk. If you invest all this money into equities, then a sudden correction or prolonged bear market could have a major effect on your capital. You would want to make sure you were diversified across a broad range of asset classes to protect the downside.

However, if you are starting a long term savings scheme for your retirement and investing $500 a month, then equity market volatility can be your friend. I’m sure by now you have heard the term Dollar Cost Averaging? If not, then take a look at this Investopedia article, which has a great video explaining how it works. A regular investment plan like this can be broken down into three stages:

1. Capital accumulation – here’s where you take advantage of the averaging effect of buying shares every month. At this stage you can allocate 100% to equities.
2. Diversified – at some point, when you have build up a weight of capital in the investment, and when current stock prices are higher than the average price you paid for them, you should diversify into an allocation that fits your strategic risk profile. There’s no fixed time frame for doing this. You need to review annually yourself or with your adviser, and when you feel you have built up enough capital that it has become a lump sum in itself, diversify across other assets.
3. Pre-retirement – this doesn’t have to be about retirement necessarily, but when you get close to using the money you will need to switch to a more tactical allocation to preserve capital. This is typically in the last 1-3 years. During the crash in 2008, many people’s retirement accounts were hit because they were still in a growth focussed asset allocation – no problem for a young person but a disaster for someone about to retire and start spending the money.

I sometimes hear the term “set and forget” for long term investments, however you should be careful about this. Even a small monthly savings plan needs to be reviewed at least once a year to check if it’s time to move into the next allocation phase. Lump sum investments also need to be rebalanced regularly, and we will cover rebalancing shortly.