The savings plan
A savings plan automatically buys the same amount every month. It doesn't earn you more. Its value is that you no longer have to decide each time.
Learning objective: After this lesson you can explain why a savings plan works mainly because it takes the decision off your hands.
You set an amount and a date, and after that everything runs by itself. No brooding over whether now is a good moment, no news to unsettle you. That's the whole trick.
More shares at low prices
Along the way you automatically buy more units when prices are low and fewer when they're high. That's often sold as a return advantage, which is an exaggeration. The real benefit is that you buy at all, even in months when it feels bad.
Compared with a lump sum
To be honest: if you have a larger sum at once, say an inheritance, on average you do slightly better investing it all straight away. Markets rise more often than they fall. A study by Vanguard found that investing in one go came out ahead in about two out of three cases. Spreading the money over a few months is still often the better choice if that's what you'll actually stick with.
How to set it up
To set it up: monthly, a broad index, executed shortly after your salary arrives. Raise the amount once a year when your income goes up. If Chiara does that by €25 every year, after ten years she's saving €250 more a month without ever really noticing. That one habit does more than any choice of product.
Because you always invest the same amount, you buy more units when prices are low. Your average price is therefore below the average of the prices. Mathematically it's the harmonic mean, and that's never bigger than the simple average. But this advantage only applies compared with buying the same number of units every month. It has nothing to do with investing in one go.
Lump sum or spread out
Comparing a lump sum with spreading it out, with a positive expected return the lump sum wins on average, simply because the money is invested longer. Spreading it out makes the outcomes less extreme and protects you from the bitter feeling of having invested everything the day before a crash. So you trade some expected return for more peace of mind.
The benefit for behavior
The savings plan does most for your behavior. Every decision you don't have to make is one less chance to get out at the wrong moment. The gap between funds' returns and their investors' returns is about as big as typical cost differences between products. A savings plan you stick with is therefore worth about as much as switching to the cheapest provider.
Summary
- The benefit is that you no longer have to decide, not a return trick.
- A lump sum is better on average, spreading it out is calmer and more likely to be kept up.
- Raising the amount once a year does more than any choice of product.
Did you get it?
Does a savings plan earn more than a lump sum?
Not on average. With a lump sum the money is invested longer. The savings plan makes outcomes less extreme instead.
What's the real value of a savings plan?
It takes recurring decisions off your hands, and with them the chances to act at the wrong moment.
Which habit has the biggest effect?
Raising your savings rate every year when your income goes up.
What others often ask about this
Lump sum or regular savings plan?
If you already have the money, historically a lump sum did better in about two out of three cases, because markets rise more often than they fall over time. A savings plan is easier to live with and fits when money comes in monthly anyway.
Should I wait for a crash before starting?
That usually costs more than it gains. Nobody knows when the next drop will come, and prices can rise a lot in the meantime.
Check your understanding
Your task
Choose a monthly amount you could still pay in a tight month and run it through the savings plan calculator over 20 years at an assumed 5 percent. Then run the same amount plus $25 and note how much the final value rises. Also write down on which day after your paycheck the plan should run.
Sources and further reading
- Vanguard's research on cost averaging shows that investing a lump sum immediately has historically produced a higher end result more often than spreading it out, simply because the capital stays invested longer on average. View source ↗
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