Investing a lump sum on the stock market: how to proceed

Last update: 17.09.2024 08:35

Is now the right time to invest? Or should I wait until the stock markets have fallen again? And isn’t it better to wait until the next recession is over? In this article, we look at how you can invest a large one-off amount in the stock market.

These questions all fall into the “market timing” category: is there a right time to enter the stock market? Can you achieve higher returns with market timing, i.e. the right time to buy and sell shares? Academics and financial experts have studied these questions extensively for decades. They have also developed various strategies on how you as an investor can overcome the fear of investing your lump sum in the stock market at the wrong time. Let’s take a closer look at these.

Growth in productive assets and inflation have the opposite effect on your assets

First of all, it is worth studying the empirical study conducted by Banque Pictet over many years. It examined how you could invest a one-off amount on the stock market. The amazing thing: from 1926 to 2018 , you always achieved a positive total return with Swiss equities over any investment period of more than 13 years. You can see this from the return triangle for the Swiss Market Index. From the beginning of 1926 to the end of 2018, the Swiss equity market gained 7.6% on average. And that’s per year! So much for your fear of “buying at the wrong time”. If you are investing for a longer period of time, you can’t go wrong with Swiss equities. At least in the past.

But if you don’t invest, you will. Because you will almost certainly lose over a longer period of time. Because inflation will gradually devalue your assets. For example, the purchasing power of cash in the USA has fallen by more than 15% in the last 10 years.

Crash timing strategy: only buy when it’s cheaper

I can hear you now saying “but the stock markets are close to their all-time high, I can’t buy right now, can I? I’d rather wait until prices have fallen.” Your statement suggests that you believe in “crash timing”. This strategy aims to buy cheaply and sell expensively. According to the strategy, you pick a broad market stock index (e.g. MSCI World or S&P500) and wait until the chosen index has fallen by a certain percentage (e.g. 20%). And then, bang, you strike, at more favorable prices, when your defined loss threshold is reached!

5% real growth in your wealth is better than watching it grow

Sounds good, doesn’t it? It may be that crash timing sounds great in theory. Unfortunately, it doesn’t work very well in practice. Here’s a fun fact. The US S&P500 index, which comprises the US companies with the largest market capitalization, trades within 5% of its record level 60% of the time. Wohoo! Oh yes, and only 12% of the time more than 20% below its last all-time high. Oops. So if you wait for a big pullback, it can firstly take a long time and secondly cost you quite a bit of return. Why? While you wait for your setback, global equities have happily achieved a nominal return of 7.5% on average every year from 1970 to 2018. Adjusted for inflation, your chapter still grows by 4.7% per year in real terms.

Crash timing strategy does not work

In a back-test for the MSCI World for the period from 1970 to 2019, financial experts have shown that the probability-weighted return of a crash timing strategy for all possible loss thresholds is between 5% and 50% lower than the return for an immediate direct investment. To put it clearly: if you wait to invest the one-off amount in the stock market, you will lose money as a long-term investor. If you still believe that you are better off with crash timing or market timing than with an immediate direct investment, there is unfortunately a lot to suggest that you are overestimating your abilities. Because even most professionals fail to do this.

Immediate direct investment” strategy: invest the lump sum directly in the stock market

The immediate direct investment of a lump sum on the stock market is therefore the strategy with the highest expected return. This is logical because, according to financial theory, higher-risk asset classes generate higher returns in the long term than lower-risk asset classes. It therefore makes sense to invest cash that is not needed immediately. This is because the markets have historically been on a long-term upward trend due to technological progress, population and consumption growth. Backtesting has shown that this has also been the best strategy over the last 50 years if you want to invest a lump sum in the stock market. Why is this the best strategy?

Falling markets are rather rare

A stock market decline with a rapid, prolonged fall in prices and a recovery lasting months or even years usually only occurs every few years. If you are not invested in a long-term rising market, this excludes you from the high probability of rising prices to higher levels. This is because even in downturns, the price level often does not fall back as far from the higher bull market level.

Cash generates little or no real return

Cash may seem safe in the short term. In the long term, however, cash is risky in terms of inflation. In the current low interest rate environment, how can you achieve a significant return after inflation with 0% in your salary account or savings account? Even if you can, the return on shares or bonds is higher. Cash therefore lowers the overall return on your investment portfolio. In comparison, this burden is lowest with an immediate direct investment, medium with a gradual investment and maximum with a crash timing strategy.

In addition to crash timing and immediate direct investment, let’s now take a look at two other strategies that you can use to invest a one-off amount in the stock market. These can be useful in certain situations.

Average cost strategy: invest the lump sum on the stock market in chunks

From a financial mathematical point of view, immediate direct investment is the strategy of choice to maximize returns. But perhaps your emotional state is more important to you and you don’t want to regret getting in at the “wrong time”? Then you find the risk of a potentially unfavorable investment timing more stressful than the loss of not getting the maximum return from your money. There may be various reasons why you perceive the investment risk to be particularly high. For example, if you want to invest a very large one-off amount in the stock market that has accumulated over time. Or if the amount only arises once, e.g. from an inheritance, insurance benefit, capital payout, sale of real estate.

Gradually shifting from government bonds to equities

If you are looking for more peace of mind, you can use the average cost strategy. With this strategy, the first step is to invest your one-off amount entirely in government bonds. These fluctuate less than shares and have a lower risk of price falls. In the second step, you sell government bonds at regular intervals, gradually and stubbornly shifting an equal amount into equities. If the price level on the stock market is currently high, you will receive fewer shares than if it is lower. On average, you achieve an average purchase price. This is below the current price level in a long-term rising market and above the current price level in a falling stock market. In addition, you can make additional purchases of the same amount if the share price falls by at least 5%, as such price falls are usually temporary.

Peace of mind has its price

With the average cost strategy, you increase the return on your portfolio compared to a crash timing strategy because you initially invest your one-off amount in government bonds. However, this strategy also falls short of the return on an immediate direct investment. Backtesting showed an average disadvantage in the return of 0.8 – 4.4%. The longer it took to switch from cash to a mixed portfolio of 60% US large cap equities and 40% US government bonds, the higher the disadvantage. The differences in returns were determined for reallocation periods of 3, 6, 9 and 12 months.

Advanced investors can invest the one-off amount on the stock market with a short put strategy

Options give the buyer the right, but not the obligation, to buy (call option) or sell (put option) a precisely defined underlying security at a predefined price. These rights are tradable and have a price. When you sell a right, you receive a so-called premium, which the buyer of the right pays you.

If you want to increase your equity exposure but wait for the price to fall, you can earn a small premium by selling put options (puts). By selling put options at a discount to the current price of the underlying (short put), you give others the right to sell you the agreed number of the underlying at the agreed price (strike price) during the term of the put. If the price of the underlying rises, you collect the premium because no one will offer to buy the underlying. The option expires worthless. However, you improve the return on your portfolio by collecting the option premium. However, if the price falls below the agreed strike price, you as the seller of the put must buy the underlying from your contractual partner at the agreed strike price. This is where the one-off amount comes into play: you use it to buy the shares / ETFs tendered to you in order to switch from cash to shares, which is what you wanted anyway.

Options trading is only suitable for experienced investors, as the strategy is not risk-free. Although the option premium received helps to increase the return on your portfolio, you bear a basically unlimited risk of loss when selling short puts, as the underlying can theoretically become worthless. In addition, if markets rise sharply or persistently, the sale of short puts results in opportunity costs because you are not invested.

Summary: Time, not timing.

The rational approach, based on financial theory, is that you should invest your lump sum directly in the stock market, immediately. The reason for this is that uninvested money achieves no return or a lower return compared to other asset classes than shares and loses value in real terms due to inflation. You can find out how to open a securities account to buy shares and what you need to look out for in this article.

However, there are various reasons why a gradual investment in the stock market may suit you better. It is practically impossible to find the right time to enter the market and you pay for this with a yield disadvantage compared to an immediate direct investment. This is because the stock market adage “time, not timing” also applies here. This means that you achieve most of the return from the investment mix and a long investment horizon, and not from your decision on when to buy/sell or when to select securities.