Averaging-in – a smoother start, but at what cost?
MAKING your first investment is arguably the most anxiety-inducing moment for any investor. It's this fear which can give us pause – waiting for the right time, usually while watching the markets climb ever higher. An alternative is to ‘average-in': to drip-feed our portfolio and transform today's purchase price to an average over the near future.
Averaging-in can sound attractive. It can turn investment hesitance into action, reduce short-term risk, and allow us to bene?t from upcoming sell-offs by being able to buy at lower prices. But with stocks generally having gone up over the long term, it's possible that the average cost will be higher than today's. So, our smoothed ride could come at a price. But that price may be worth paying because it provided the comfort to help get on board.
To see how this works, we will examine the effect of ‘averaging-in' through 2016. Let's compare investing everything at the start of the year with a commitment to a regular investment of 20 per cent of starting assets every three months (including 20 per cent invested from day one) in a moderate risk portfolio.
Looking back, investing little by little dampened the effect of a dreadful January, but markets went on to recover strongly, and by the end of the year both investors would have enjoyed positive returns. The averaging-in strategy produced a smoother ride, but, being only part-invested through most of the year, was only part-rewarded.
Still, the most important thing is to be well-positioned for the future, and even if it took a while longer to get there, the averaged-in investor is now positioned to take advantage of the higher expected returns from investing than if they had remained in cash.
We can run this simulation further back in time, to see how it has typically played out. We looked at the same two strategies using monthly data from January 1990 to March 2017. Across the 315 possible start months, investing on day one would have produced a higher one-year return than averaging-in on 216 occasions – over two-thirds of the time.
Unsurprisingly, we observe a narrower range of 12-month returns for the averaged-in portfolios compared to those fully invested from day one. Using the inter-quartile range (IQR) of returns as a measure of variability, we get a spread of 4.9 per cent for the averaged-in portfolios compared to 10.5 per cent for those fully invested from day one.
This reduction in uncertainty came at a cost, however: a median excess return of just 3.2 per cent for the former versus 5.8 per cent for the latter. But for many investors, giving up a small amount of return to reduce ?rst year variability in performance by half may be a price worth paying.
Since investing is a long-term activity, we compare returns over timeframes stretching beyond the ?rst year. From this point, both strategies are fully invested, so experience the same monthly returns. Perhaps surprisingly, we ?nd that beyond about ?ve years, the spread of outcomes for the averaged-in portfolios turns wider. Unfortunately, the pattern of lower median returns from averaging-in is not reversed. Historically lower and riskier average returns in the long term are a strong argument against averaging-in.
Short-term investments have a typically wider spread of annualised returns than those left for a full market cycle. Long-term investment requires the ability to overcome turbulence, particularly in the ?rst few years when it's quite possible that capital may dip below its initial value.
Averaging-in to the market can dampen the extent of these early losses, and may help overcome any fear that the next downturn is just around the corner. But it comes at a cost of lower average returns, and a longer time to reach ‘mature' spreads of annual returns.
Investor behaviour is a balance between accepting these costs and the comfort they bring. For an investor nervous about the immediate future, giving up a small amount to get invested may make a lot of sense.
But if markets perform well in the long term – the very case for investment in the ?rst place – then if you can, you're better off (on average) not averaging-in.
:: Jonathan Dobbin (email@example.com) is head of wealth and investment management NI at Barclays. He can be contacted on 028 9088 2925.