Phasing
Huong Tran & Peter Daly
Associate Director, Portfolio Management | Head of Multi Asset Solutions
Investing lump sums - Phasing versus all-at-once
Investors with a lump sum of cash face several important decisions. Having prepared a detailed financial plan with an advisor, incorporating their liquidity needs, financial goals, time horizon, risk tolerance and investment experience among other factors, often the most difficult step is the move from cash to a fully invested portfolio. In this article, we explore the benefits and drawbacks of investing in the market over time, known as 'phasing’, compared to investing your money all-at-once.
Phasing is often the preferred strategy, especially during periods of market volatility like 2022, as it is seen as a way of reducing risk versus the all-at-once approach. However, it is worth examining the pros and cons of each approach. We also explore the impact of an accelerated phasing method, which involves speeding up the phasing process based on an equity market signal.
Phasing: A safer approach, but not without cost
For those who have just sold their business, received an inheritance, retired their pension and received a lump sum, or who have been saving and accumulated a savings pot they are ready to invest, a key concern is the deployment of cash into the chosen investment strategy. What if the market falls immediately after investing the entire sum? This is a valid concern and a primary reason why the phasing method is often used.
Behavioural bias is an important consideration when deciding whether to phase investments. Daniel Kahneman’s research showed that investors typically react twice as emotionally to losing money as they do to making money. This tendency for “loss aversion” means that investors are often willing to sacrifice returns (i.e. be out of the market) to protect their capital. A phased investment strategy will help to smooth out the effect of market changes on the value of the portfolio.
Ultimately the most important thing is for an investor to be able to live with their investment portfolio and not change course at the wrong time. But while a phased investment strategy can reduce some downside risk, it does mean being out of the market for some time. And as with any risk reduction strategy, phased investing is also likely to lead to lower returns.
Phasing can be implemented over different timeframes, for example from 3 months, up to 12 months, depending on the investor’s circumstances. Generally, it is not advisable to phase over a period of more than one year because the cost of staying out of the market that long can be significant and impact longer-term investment goals.
A popular strategy, and one we use in Davy, is to phase over a 6-month period, with 50% invested immediately, 25% in 3 months' time, and the final 25% in 6 months' time. Others use a simple equal-weight strategy with one-third invested immediately, one-third in 3 months' time, and the final third in 6 months' time. Testing different allocations for phasing shows largely the same results over the long term. Front loading the initial phase tends to give a slightly better expected outcome given markets trend upward over time.
Figure 1: Transition to target portfolio
Source: Davy
Investing in phases can be beneficial for investors if the market suffers a downturn during the phasing period. This strategy is often considered a safer approach, offering protection against a sudden market sell-off. However, there are drawbacks to the approach. The principal drawback is the divergence between the asset allocation during the phasing period and your target allocation. For instance, if your goal is a 60/40 strategy (60% equities and 40% bonds), a phasing plan like 50/25/25 means it will take 6 months to reach your intended allocation. This lag will result in your portfolio not aligning with your desired risk and return profile during the phasing process. Uninvested cash, which is inherent in the phasing strategy, can act as a drag on returns. While waiting to deploy all the capital over the specified period, the uninvested portion may not be earning returns, potentially impacting the overall performance of your portfolio. As we show below, cash drag on average is expected to lower portfolio returns versus all-at-once.
Investing all-at-once
Investing all your capital immediately means achieving your target allocation on day one. As we show in the next section, this method has a better expected return outcome than phasing and minimises the risk of missing out on the market's best trading days. However, even with a low chance of underperforming phasing, investing all-at-once assumes the risk of investing before a crash and associated behavioural errors that may ensue.
Phasing versus all-at-once
In this section, we analyse the two most common phasing methods and compare them to the strategy of investing all-at-once. The portfolio used in this analysis is a classic 60/40 portfolio, comprising 60% US Equities (S&P 500) and 40% US Treasuries, over the period 1987- 2023. We measure the investment outcome over every 10-year window in this period.
The results show that over this time investing all-at-once produces a better 10-year outcome compared to a phased approach roughly 80% of the time. On average, a phasing strategy of 50/25/25 underperforms all-at-once by 4%, and a phasing strategy of 33/33/33 underperforms all-at-once by 5.3% (in absolute terms, non-annualised).
Figure 2 shows the average terminal value after 10 years of a portfolio with a starting value of $1m. An all-at-once approach yielded almost $2.4m on average, circa $40k to $50k more than either of the phasing approaches.
Figure 2: Average outcome of investing all-at-once versus phasing
Source: Bloomberg & Davy, data covers from December 1986 to November 2023
Figure 3 details the findings in deciles. The worst 10% of periods for phasing resulted in a total underperformance of 11.7% and 15.6% respectively. The best 10% of periods for phasing result in an outperformance of 2.9% and 3.9% respectively, showing that the outcomes are skewed in your favour by investing immediately. This highlights the principle that the earlier you start investing or the longer you stay in the market and allow the power of compounding to take effect, the better the outcome you are likely to get.
Figure 3: Phasing versus investing all-at-once
Source: Bloomberg and Davy, data covers December 1986 to November 2023 Note: Returns shown are absolute returns, non-annualised, calculated per a 1 million initial investment.
Accelerated phasing
Next, we examine the potential to enhance the process by accelerating the phasing when we observe a drop in the equity market of 10% or more. During the period 1987-2023, we did not observe a market drop of 10% or more during 78% of all 6-month phasing windows, and therefore no acceleration would have been triggered. However, in the 22% of cases where we did observe a drop of 10% during the phasing window, accelerated phasing produced better outcomes more than twice as often.
Figure 4: Comparison of average outcomes of different phasing approaches vs all at once
Source: Bloomberg & Davy, data covers December 1986 to November 2023
Conclusion
Our results emphasise the benefits of investing all-at-once over the long term. Yet, we recognise that individual circumstances differ. Investors with capital to invest that is a large proportion of their net worth or those with less market experience may prefer the comfort of phasing.
Each investment journey is unique, and we're here to discuss the strategy that is most suitable for your goals and comfort level. While phasing offers a safer route for your lump sum, it is important to acknowledge the associated drawbacks, including divergence from your target allocation and the potential impact of uninvested cash. Please speak with your dedicated advisor to explore the best approach for your financial future.
Warning: Past performance is not a reliable guide to future performance. The value of your investment may go down as well as up. These products may be affected by changes in currency exchange rates.
Warning: Forecasts are not a reliable indicator of future performance.
Warning: The information in this article is not a recommendation or investment research. It does not purport to be financial advice and does not take into account the investment objectives, knowledge and experience or financial situation of any particular person. There is no guarantee that by putting a financial or investment plan in place, you will meet your objectives. You should speak to your advisor, in the context of your own personal circumstances, prior to making any financial or investment decision.