One of the biggest dilemmas investors face is market timing. Jumping in and out of markets on a regular basis not only requires constant monitoring of daily events but also requires the skill to act on such events. Even the best fund managers, such as Warren Buffett, avoid trying to catch the top or bottom of a market. It’s impossible to time markets perfectly, so it’s best not to attempt it.
But that leaves us with a quandary: we want to invest and achieve the best returns for our future but we don’t want to put our hard earned capital at risk just at the wrong time. What we want to do is improve our chances of entering the market at the right time. One way to achieve this is to spread or drip-feed one’s lump sum into the market as opposed to investing it all in one go. In fact during volatile times this strategy allows one to benefit from what is known as ‘pound cost averaging': a simple, time-tested method for controlling risk over time.
How It Works
The concept of pound-cost averaging is simple; the term simply refers to investing money in equal amounts at regular intervals. Most funds, whether they are OEICs or investment trusts/closed-end funds, are available through regular savings plans (such as ISA schemes), allowing an individual to invest on a monthly basis. In fact, if you have a defined contribution pension plan, you've probably already been pound-cost averaging by paying a set monthly amount direct from your pay cheque.
One reason pound-cost averaging is so attractive is that it forces you to invest no matter what the market is doing, thus helping to avoid the poor decisions most people make when trying to time the market. When the stock market is going down, lots of people become fearful and reluctant to put money into stocks. That may help avoid some losses in the short term, but when markets eventually start going back up someone who has avoided stocks will lose out on the gains. Those who invest a fixed amount every month, on the other hand, will be in a much better position to benefit when the market bounces back, and meanwhile they'll often be buying stocks at bargain prices.
In a bull market, the opposite is true: pound-cost averaging prevents you from getting carried away and putting too much money in stocks that may be too expensive and poised for a fall. In the raging bull market of the late 1990s, lots of otherwise rational people were swept up in the mania and loaded up on stocks trading at exorbitant prices; when the market crashed, many of those investors got badly burned. Investors who pound-cost averaged their investments missed out on some of the upside at the height of the bubble, but they were generally in much better shape when the market went south. This is an important point to note: pound-cost averaging aims to reduce volatility but this does not mean it will increase total return--this strategy enables you to avoid the worst of the market's moves and therefore means you'll also miss the highs.
Why It's a Good Idea
Pound-cost averaging can help investors limit losses while also instilling a sense of investment discipline and ensuring that you're buying shares at ever-lower prices in down markets. Numerous studies have confirmed that it also results in better returns than strategies that involve moving in and out of the market.
For example, a study by Fidelity in the US looked at how several different strategies would have performed from January 2000 to January 2004, a period that included both a bear market and the start of a recovery. The study found that the best results came from steadily investing $500 every month into an S&P 500 stock portfolio. This pound-cost averaging strategy (or dollar-cost averaging, in this case) even outperformed a "bear-market dodger" strategy that started putting all its new money into cash in April 2000, at the height of the market bubble. Strategies that shifted into cash after the market had declined 20% (bear-market refugee) or at the market bottom (doomsday capitulator) did even worse.
How To Do It
If you decide that pound-cost averaging is a good idea there are a number of ways to implement such a plan. If you're really disciplined, you can set one up on your own, figuring out how much you want to invest and then sending in a cheque each month. However, most people find it easier to stick to a pound-cost averaging plan that's set up to work automatically. As noted above, most defined contribution pension plans involve a form of pound-cost averaging, as they take a fixed percentage of your salary and invest it in a prearranged group of funds or other investments. It's best not to mess around too much with the percentage you contribute to your pension. The advantages of pound-cost averaging will be diluted or lost if you change this percentage in response to market conditions, for example by cutting back your contribution when the market is going down.
Many stockbrokers and fund supermarkets also have automatic investment plans that allow you to invest a fixed amount automatically every month. In many cases, the minimum initial investment needed to get into these products is much lower if you set up an automatic investment plan; this makes such plans especially attractive for children or recent university graduates who want to invest but don't have a lot of money up front. Another option is to set up an Individual Savings Account (ISA) with a fund provider or fund platform; the latter gives you a wide choice of funds to pick and you can invest your regular payment in a number of funds rather than hone in on just one. The beauty of an ISA is that you can pound-cost average your way to an annual pot of £11,280 for the next 2012-2013 tax year, which is the annual contribution limit. And when it comes to selling your investments you won't have to pay income or capital gains taxes. Note, however, that pound-cost averaging may not be feasible if you have to pay lots of brokerage commissions every time you invest, so it's best to make sure that won't be an issue before you set up a plan.
This story was originally published February 2011 on Morningstar.co.uk.
