Learn About Investing
‘Buy low, sell high’. No one would argue with that. The tricky bit is knowing when the market is at a low-point or on a high.
No one knows the answer for sure - unless you think humans really can see the future. The best informed investors may be more accurate when it comes to predicting what happens next, but even they frequently get it wrong. Ultimately, stockmarkets can be volatile and unpredictable.
Historically, the bulk of long term stockmarket returns have been generated on a relatively small number of bumper days. So, being out of the market at such moments can be costly over the long term.
Given this uncertainty, it is unlikely you will get your timing just right, ensuring you always buy at the bottom and sell at the top.
It may be an idea not to even bother trying. Overall, the chances are you’re more likely to lose out than you are to gain by attempting to time the market. One approach is to sidestep the issue by not investing in one go, rather doing it gradually instead.
It’s a myth that investing only makes sense for people who have sizeable lump sums at the ready. Setting aside a relatively small amount to invest regularly, typically every month, doesn’t sound like a very exciting investment strategy but can be highly effective.
Firstly, if you set aside a small portion of your income every month, you will get into the habit of investing without it hurting too badly. As with any direct debit, if the money automatically leaves your account there is a chance you notice it less and adjust your day-to-day spending naturally. Getting together a large lump sum can feel much more daunting than the little and often approach. Secondly, you avoid stress associated with timing the market – namely seeing your investment lose value straight after buying it. The price may later recover, but you could feel very anxious in the meantime.
Also, if you are investing a fixed amount each month, the money will buy you fewer shares in a month when the market is riding high and shares are relatively expensive. That doesn’t sound great, but then again in a month after the market dropped, the price of each share is less and you will acquire more of them. Over time, the upshot is that you pick up more shares when they’re cheaper than when they’re pricey.
This is significant because it drags down the average purchase cost of each share. The technical name for this is pound cost averaging (or dollar cost averaging in America). This strategy is particularly effective in volatile or bear markets, when share prices are bouncing around or down.
While the little and often habit applies just as much to saving cash as it does to investing, pound price averaging is specific to investing. Until recently, the minimum monthly investment plan was typically £50 – but there are now plenty of exceptions and as little as £1 can be set aside.
Little and often tots up
“£50 a month invested regularly over five years in the average investment company is now worth £4,041” (a gain of £1,041)
Independent, 6 April 2013
Lump sum investing
For those with lump sums, there is a natural fear of getting your timing wrong and investing it all just before the stockmarket takes a dive. So, does it make sense to dribble it in gradually, taking advantage of pound cost averaging?
Over the very long term stockmarket prices have trended upwards. At least this has been the case historically (sadly there is no law saying it is inevitable in future). The upshot is that by holding on to cash you risk losing out on potential gains.
As such, if a lump sum is being invested over the long term it may be better to take the plunge and commit the whole lot straight away. Looking back as far as the 1920s, research by Vanguard found that two-thirds of the time doing this panned out better than dribbling the investment in over a period of months or years.
Investing a lump sum can favour long-term investors, but pound cost averaging will appeal to those with lower appetite for risk or who may need to access their money. Even if the long term stockmarket trend is up, shorter term volatility could hurt severely if you aren’t able to ride out a downturn. That could mean you need to hang on several years for prices to recover. Otherwise, you could be forced to sell at a loss.
- Trying to time the market can be hazardous!
- If you have a long investment horizon, you may be better off investing a lump sum in one go (assuming markets do ultimately continue to trend upwards)
- Monthly investing has the benefits of minimizing the emotional aspects of investing and managing risk in times of market downturn.
Although lump sum investors may amass more over time, pound cost averaging might be more realistic from a logistical and psychological standpoint.
Comparing the historical performance of pound cost averaging with lump sums. The case for lump sum investing.
Surprisingly, there can be a positive side to volatile or bear markets. Pound cost averaging comes into its own in such market conditions.
Monthly investing is one of the simplest ways to combat volatility because the value of your investment will not change dramatically.
The two main ways of investing your money is either as a lump sum or through regular investment (typically monthly).