There has been a lot of volatility in the stock market in recent weeks, and you will have heard how at one stage the Dow Jones was down 1,000 points and the FTSE had seen £70 billion wiped off its value in just one day of trading.
It was hardly surprising that most of the recent queries I have been receiving are from people asking whether now is the right time to invest in the stock market. Should they take out what they have and wait until markets calm down?
My advice to anyone in this regard is never try to time the market, because the chances are you will be unsuccessful. Unless you have a crystal ball, you don’t know what will happen.
Some experts will tell you the time to invest in the stock market is whenever everyone else is cashing out. Some professional investors feel the right time in this regard is when markets have fallen by 5%, which is their trigger point to enter the market; this is known as “investing on the dips”. On the other hand, people like Warren Buffet will tell you the time to get out is when everyone else is getting in.
As I said, trying to time the market and catch the top or bottom of it is next to impossible. Even the very best fund managers say it is best not to attempt it.
Is there a way that you can both invest at a time which reduces your risk but also improves your chances of entering the market at the right time; where you didn’t have to rely completely on guess work? Well, there is, and in the financial services industry the term is known as pound cost averaging.
Pound cost averaging is where you save a fixed regular amount each month, like when you put money into a pension fund.
By doing this you are buying units in a fund at a different price each month, rather than buying at one price as is the case if you were investing a lump sum. When the market reduces then your regular saving will buy more shares. When the market rises you will buy fewer, but the shares you bought in the previous months will be worth more.
Say, you have €10,000 to invest and you use this lump sum to invest in a fund at an initial price of €10, which means you now have 1,000 units in that particular fund. What you don’t know in this instance is whether €10 was a high or low price to pay per unit.
If you bought €278 worth of units each month over a three year period (amounts to €10,000 over that time period), you would have bought 27.8 units in the first month (€278/€10)
But if the unit price went down to €9.00 in month two, you would be able to buy 30.80 units, as the units were at a lower rate (€278/9). But because you bought at a higher rate in month one, the total value of your investment in month two has only reduced by €27.80.
If you invested the full €10,000 as a lump sum at €10 per unit and it now has dropped to €9 in month two, your fund is now valued at €9,000.
Both funds have reduced by 10% but the lump sum is worth €1,000 less and the regular savings one is down by just €27.80. This is down to the amounts invested to date.
Based on this example, you would think it would be better if you put €10,000 into a capital secure account and set up a standing order and saved a regular amount into a stock market related fund because this would mitigate your risk. And it would, but investing a lump sum straight into a stock market fund gives you a greater chance of higher returns than by saving regularly because it is immediately exposed to the market.
And if the returns were exactly the same if you invested every month as if you invested a lump sum, then you would think the returns would be exactly the same but think again because they wouldn’t.
If you invested €4,800 at a return of 3% it would generate a return of €146 after one year, but if you invested €400 per month at a rate of 3%, your return for the year would be just €66.55.
I did an exercise for a client recently who set up a regular savings account five years ago where he saved €500 every month and his return was very good at 15% – he made €14,287. If, however, he deposited the €30,000 he had instead as a lump sum, his return would have been €33,215.
There are pros and cons to each way of investing and other factors will also influence your decision like your attitude to risk, your particular circumstances, your time horizon, your end goal and so on.
Over the long term, investing a lump sum has proven to be the method that generates the biggest return and whilst you are exposed to downward movements in the stock market in the short term, if you have the ability to stay invested over a longer period of time, say five to seven years, where you have the time to ride out the highs and lows, giving you the opportunity for your money to recover, you will probably work out better.
It is over shorter periods of time when markets are particularly volatile, when regular savings and the pound cost averaging concept has proven to be the most effective way of investing.
Maybe your best bet is hedging your bets and invest using both methods.