FOOL'S EYE VIEW
Should You Drip Feed or Invest a Lump Sum?

By David Kuo (TMFDragon)
May 1, 2001

Carburton Street, London -- Investors are sometimes faced with the problem of how to invest a lump sum in the market. Their most frequently asked question is whether it is better to drip the money into their chosen investment or alternatively invest the whole lot in one fell swoop. We are assuming of course that these investors have considered paying off any outstanding debts and have reduced their mortgage burden.

But before we get going with the numbers, let's have a bit of theory on market timing because this is the real crux of the matter.

Consider a deck of shuffled playing cards. Deal the cards, face up, one at a time and try to guess in advance whether each card will be black or red. The chances are you will be right 50% of the time. Attempting to predict future movements of a stock price is a bit like guessing the outcome of that next card. There is however one significant difference, namely over the long-term share prices have shown a tendency to move higher.

A Random Walk Through the Markets

Random walk theory asserts that past performance of a share cannot be used to predict future stock prices. This is because share prices do not have a memory. The behaviour of a share price from one moment to the next is completely random but over the longer term, the stock price has a proclivity to move higher. This observation is more reliable if we consider an index, which is a measure of the value of a portfolio of stocks. By considering an index, anomalous price movements in specific stocks are smoothed out to produce a better reflection of the market as a whole.

It has been shown that over the long term, market indices have moved up on 70% of trading days and declined on just 30%. So, in theory, there should be no discernible difference between investing the whole amount in one go and dripping the investment into the market slowly. This is because it is not possible to determine beforehand whether the market will be higher or lower tomorrow. But let's take a look at some numbers to see how this pans out in reality. We have chosen the FTSE All-Share index to illustrate four separate scenarios.

Some Specific Examples

In 1993, the FTSE All-Share index rose steadily from 1363 to 1682. A lump sum investment in an All-Share tracker fund at the start of the year would have been in profit to the tune of 23% by New Year's Eve. Project this forward five years to the end of 1997, when the index stood at 2411, and the annualised return comes in at 12.1%.

If the same sum of money were dripped into an index tracker over the twelve months in that same year, the annual return would drop to just 16% compared with 23% with the lump sum investment. At the end of the five-year period, the annualised return would have been 10.7%.

The picture in 1994 was somewhat different to the previous year. During this period, the FTSE All-Share index was in decline. It started the year on a high note at 1682 and worsened steadily throughout the twelve months to end at 1521. The same lump sum invested at the start of the year would have shown a loss of 9.6% by the year-end. However, five years down the line, with the index at 2673, the investment would have produced an annualised return of 9.7%.

Had the investment been dripped into the market during 1994, the loss for the twelve months would have lessened to just 3% compared with a loss of 9.7%. If we fast-forward five years, the annualised return now jumps to 11.3%.

So What's the Answer?

The four examples depict lump sum and drip feed investments in both a rising and falling market. When the market is on the up, getting in early with a lump sum produced the best return. At the other end of the scale, plumping for a lump sum investment in a declining market can be less profitable. The compromise situation of dripping into the market would smooth out any anomalies and this also appears to give a more even return regardless of market direction.

Interestingly, the returns on investment tend to revert to a market average as time progresses. By the end of year 2000, all four investment scenarios start to cluster around an annualised average return of about 9.5%.

Clearly, market timing can be beneficial in the short term. However, over the long haul, there is little to choose between investing the whole amount at once and drip-feeding gradually. The option of investing a lump sum may not be possible for many of us. What is undeniable, nonetheless, is the need to formulate a coherent investment plan, no matter how modest, and start investing now.

More: The Motley Fool ISA Centre.