If turbulence in the stock market is making you nervous, here's why now could be the wrong time to pull out.
The FTSE 100 index fell over 11% in September. That’s easily enough to get many UK investors' nerves jangling.
If you have a share-based pension fund, a stocks & shares ISA or invest directly in shares yourself, you may be thinking now is the time to get out of the market before it drops any further.
But you shouldn’t let short-term blips put you off. You only risk losing any cold hard cash when you sell-up, so think carefully before you do anything. After all, for most of us, investing should be thought of as a long-term strategy. Timing the market correctly on a consistent basis is extremely hard even if you’re an experienced investor. If you know someone who has successfully timed the market again and again, luck may have been a factor....
How do you cope with stock market turmoil?
My advice is to continue as you were before. If you’re investing every month into your pension or an ISA, a volatile market can actually give your investment a helping hand.
By drip-feeding money into your plan, you can take advantage of what’s known as ‘pound cost averaging'. Pound cost averaging allows you to enjoy the upturns in the market while softening the slumps.
How does pound cost averaging work?
Pound cost averaging only works if you invest on a regular basis. Let’s imagine you contribute £100 a month in a personal pension scheme. If you invest the same £100 every month, each contribution will buy shares -- or units if you’re investing in a unit trust -- at a range of different prices as the market fluctuates. So when the market is climbing you’ll purchase fewer shares with your £100, but when the market is falling you’ll buy more shares with the same £100.
Ok, that’s not rocket science, but this is the clever bit: By investing regularly over any period, the average price you’ll pay for your shares/units will always be lower than the average market price. And this applies whether you’re investing in a rising or falling market.
This is how it works:
Contribution | Share/unit price | Number of shares/units purchased |
|---|
£100 | £1.50 | 66.6 |
£100 | £1.38 | 72.5 |
£100 | £1.25 | 80 |
£100 | £1.09 | 91.7 |
£100 | £0.95 | 105.3 |
£100 | £0.88 | 113.6 |
Average share price/total number of shares purchased | £1.18 | 529.7 |
Using the example shown above, the average share/unit price would be £1.18 after investing in your pension plan for six months. In that time, you would have bought 529.7 shares/units. So based on your total contributions of £600, the average purchase price you will have paid is just £1.13. That means pound cost averaging has saved you 5p per share. Not bad!
The table below also shows the benefits of regular investing compared to investing a single lump sum in a falling market for one year:
Investing regularly versus investing a single sum
Month | Share/unit price | Number of shares/units purchased (monthly) | Number of shares/units
purchased
(lump sum) |
|---|
January | 1.11 | 90.1 | 1081 |
February | 1.11 | 90.1 | 0 |
March | 1.10 | 90.1 | 0 |
April | 1.14 | 87.7 | 0 |
May | 1.12 | 89.3 | 0 |
June | 1.10 | 90.1 | 0 |
July | 1.02 | 98.04 | 0 |
August | 0.91 | 109.9 | 0 |
September | 0.92 | 108.7 | 0 |
October | 0.82 | 122.0 | 0 |
November | 0.86 | 116.3 | 0 |
December | 0.91 | 109.9 | 0 |
Total Units purchased | - | 1202.24 | 1081 |
End Value | - | £1,094.04 | £983.71 |
Source: Morningstar
It’s easy to see how the value of your investment can benefit from pound cost averaging in a falling market. By investing £100 each month into your pension, your end value would be £110 higher than it would be had you invested £1,200 as a single lump sum at the beginning of the year.
That said the reverse is true in a rising market, where you would be better off investing a lump sum at the bottom of the market, rather than investing each month. But timing the bottom off the market is almost impossible. Whereas investing regularly means you don't need to worry about picking the right time to dip your toe into the market.
If you’re paying a monthly amount into a pension or an ISA, don’t be tempted to cancel your contributions just because the stock market is looking a bit dicey. If you’re drip-feeding cash, there's no need to even think about timing your investments correctly. Pound cost averaging will work its magic for you!
I really don't think you should feel too gloomy about investing in a falling market. Take my SIPP -- Self-Invested Personal Pension -- for example. I started investing into the plan less than two months ago and already 13% has been wiped off its value. But I’m not too concerned about it. I see it as an opportunity to buy a lot more units at a lower cost with the same monthly pension contribution. When the market recovers again, the units I bought at a knock-down price will be poised to recover.
So you could argue now is actually a very good time to invest. Good luck!
More: Four Steps To Protect Your Portfolio From Financial Crisis | Invest in a Stocks & Shares ISA through The Fool
