Investing In Volatile Markets ? Pound Cost Averaging

06.09.11

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Stockmarkets have been having a tough time recently, with share prices rocked by uncertainty and investor fear. Investors tend to fear losses more than they crave gains, and it?s cer

Stockmarkets have been having a tough time recently, with share prices rocked by uncertainty and investor fear. Investors tend to fear losses more than they crave gains, and it?s certainly no fun watching your investments fall. During times of volatility those who are already invested get tempted to sell to prevent further losses, while those with capital in the bank continue to sit in cash, too nervous to invest at the present time. But what should you be doing?

The recent volatility has underlined the case for a long-term approach to equity investment. Share prices constantly change, which is how they generate returns, but along the way they do go down as well as up and you need time for the downs to be ironed out. Unpredictable events and investor sentiment can negatively impact share prices, but the short-term declines should not detract from the long-term potential of equity investment.

I recently saw an interesting chart prepared by asset management firm BlackRock. It covered performance of UK equities (FTSE All-Share index), bonds (the FTSE Actuaries UK Gilts All Stocks Index) and cash (average UK deposit account rate) over 25 years. It marks the noteworthy events along the way, such as the 1987?s Black Monday, the two Iraq wars, the dot.com boom, September 11th, and Lehman collapse and ensuing bear market.

It showed that ?10,000 invested in equities on 31st December 1985 had grown to ?112,831 by 31st December 2010. In comparison bonds returned ?77,984 and cash ?23,273.

If you put aside economic uncertainty and investor sentiment, company fundamentals are better than you may expect. For example, in the US stock fundamentals are strong, business spending is solid and commodity-based inflation has been reduced. The latest earnings season is drawing to a close. As at 18th August 459 of the S&P 500 companies had reported their second quarter results and the numbers have looked strong, with 71% beating expectations and all but one reporting earning growth of between 11.8% and 17.9%. As at 12th August, second quarter revenues had also grown an estimated 11.14% year on year, better than expected. Revenues are a more direct reflection of healthy global demand.

On top of this, valuations across global equity markets are attractive on an historic basis, and recent market falls have strengthened the valuation case.

These market falls, however, make current and potential investors nervous.

At times of market volatility, those with capital to invest think they are better off sticking to cash, at least until markets have improved. However it takes them so long to get the confidence to invest that, by the time they do, they?ve missed much of the market rises that come when markets rebound.

Even if logically they realise that investing when markets have fallen means that shares are better value, many are still understandably nervous and find it hard to take the step to invest all their cash.

It is possible to reduce exposure to short-term market volatility by spreading your investment over time. The technical term is ?Pound (or Euro or Dollar) Cost Averaging?, also referred to as ?drip feeding? or ?phasing?. It?s commonly used for savings plans but can also be used to invest a lump sum. For example, if you have ?100,000 to invest you can invest ?25,000 at a time, spread over a number of months.

This strategy potentially produces both a smoother return and a greater return overall. Over a period of time, more units can be purchased as when prices fall your money buys you more units. When prices rise you?ll buy less units, but at the same time the ones you bought previously have risen in price. The more prices fall between purchases, the more shares you can buy next time ? so stockmarket volatility would therefore work in your favour over the longer term.

At the end of the period, the average cost per unit can be less than the average market price over the same period, or the average cost of a lump sum investment.

With pound cost averaging you can make money over a flat period, i.e. where the unit price is the same at the end as the beginning, but has dipped in between.

What about existing investors? Although it is tempting to sell investments when prices are falling it would mean that you lock in what would otherwise just have been a paper loss. Your shares won?t have the opportunity to recover their losses when markets move up again ? albeit we don?t know when this will be. Missing even a few of the best performing days can result in significantly lower returns than the market index and being out of the market can mean you miss the market rallies that can substantially improve your overall returns and long-term wealth.

Provided you have a long-term time horizon, rather than selling at a loss you could view market falls as an opportunity to buy additional shares at ?sale? price and boost your portfolio?s long-term return potential when the market rebounds.

If you do have cash available to invest, you could either do a one-off additional purchase of shares or, as described above, phase the capital into the markets. It can work well for investors who?ve currently made a paper loss on their investments. When prices rise their original assets will return to their original price and the new ones will make a gain.

The effectiveness of the pound cost averaging strategy does depend on the time horizon, frequency of investments and market performance (if prices only move upwards you?ll miss out on some gains). As always, you should discuss your options, objectives and circumstances with an experienced wealth manager like Blevins Franks to establish what approach would be best for you.

Remember also that the most effective way to protect your purchasing power of your savings for the longer term is to be invested in a wide spread and have a diversified portfolio of assets such as equity funds, fixed interest bond funds and property funds.

By Bill Blevins, Managing Director, Blevins Franks

26th August 2011

Tax rates, scope and reliefs may change. Any statements concerning taxation are based upon our understanding of current taxation laws and practices which are subject to change. Tax information has been summarised; individuals should seek personalised advice.

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