‘Buy at the bottom, sell at the top’. We have all heard that seemingly simple advice on how to make a fortune on the markets, but putting it into practice is altogether another matter.
In spite of overwhelming evidence to the contrary, many retail investors believe that such market timing is possible. After over a decade of equity bull markets on both sides of the Atlantic, that misplaced belief is now prompting more potential investors to stick with their deposit accounts, biding their time, despite miserably low interest rates.
The strategy has been failing for years – one reason why the current USA bull market has been labelled ‘the most-hated bull market in history’. Peter Lynch, one of the most famous USA mutual fund managers, summed it up neatly when talking in a different era: “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves”.
Given the near impossibility of perfect timing, the theoretical investment approach is simple: take the leap and fully invest at day one.
Over the long term, the trend of markets is generally upwards, so the earlier an investment is made, the better. Research supports the idea: taking a look over many decades at UK, USA and Australian stock markets, analysts concluded that on about two thirds of occasions, a one-off investment at day one produced a better return than investment phased evenly over the following 12 months. The average gains were 2.39% (USA), 2.03% (UK), and 1.45% (Australia).
As you will have experienced with real world clients, for many the answer is no. For a start, if two thirds of the results are better, then one third are not. Secondly, the fact that the one-off approach wins overall by about 2% has a direct relationship to risk, particularly in markets prone to bouts of volatility (notably the UK and USA of late).
The chance of the one-off investment occurring before a market decline is what has kept retail cash piling up on the sidelines. Behavioural finance offers an explanation in terms of loss aversion: pound for pound, the pain of a loss is twice the pleasure of a gain according to research.
All of which takes us back to the phased investment option.
For the more risk-averse investor, the possible downside of a marginally lower return than from one-off investment comes with three important upsides
- The chances of making a single investment at the wrong time are reduced;
- They are investing in the markets, which they otherwise might not do;
- Taking the plunge ensures tax allowances are secured regardless of how markets are behaving;
- and They are benefiting from pound cost averaging.
Pound cost averaging is usually thought of in terms of regular savings plans but is equally relevant to the phased investment approach. The advantage of pound cost averaging is that if a fixed sum is invested regularly (typically each month), then more units/shares are bought when the price is low than when it is high.
The net result being sought is that, at the end of the investment period, the average price paid is less than the average price across each of the buying days.
Putting phased investment into practice is relatively easy for your clients, though it is to some degree dependent on your preferred platform (some do not offer an automated solution).
The points to consider are:
- Can you choose the term for phasing? This is important as every client has different needs and ideas. You may need to be specific if you are thinking of ISA or pension tax year investment limits
- Is there the option of a different phasing period and to phased into another fund selection for different wrappers?
- Is there a manual override? Sudden sharp market movements might point to a change of approach.
- Are there any additional charges or cash management constraints for phasing?
For some clients that automated, smoothed system of investment may be the deciding factor when neither of the other options - one-off investment or 1% deposit interest – has any great appeal.
Pound cost averaging – an example
Assume that £1,000 is invested on the last business day of each month from 28 September 2018 to 30 August 2019 in the FTSE All-Share Index. The results would be thus:
|Date ||FTSE All Share ||Amount purchased |
|30 Sep 2019 ||4,061.74 || |
|30 Aug 2019 ||3,953.02 ||0.252971146 |
|31 Jul 2019 ||4,134.03 ||0.241894713 |
|28 Jun 2019 ||4,056.88 ||0.246494843 |
|31 May 2019 ||3,923.87 ||0.254850441 |
|30 Apr 2019 ||4,067.98 ||0.245822251 |
|29 Mar 2019 ||3,978.28 ||0.251364911 |
|28 Feb 2019 ||3,888.81 ||0.257148074 |
|31 Jan 2019 ||3,825.62 ||0.261395539 |
|31 Dec 2018 ||3,675.06 ||0.272104401 |
|30 Nov 2018 ||3,823.34 ||0.261551418 |
|31 Oct 2018 ||3,904.23 ||0.256132451 |
|28 Sep 2018 ||4,127.91 ||0.242253344 |
| || || |
|Total purchased ||3.043983532 |
| Average index purchase price || ||3,942.20 |
|Average index || ||3,946.59 |
The difference between the average purchase price and average index on the 12 buying days is small – but still favours the phased approach – because the market was relatively stable in 2019. Often the examples provided to demonstrate pound cost averaging use unrealistically high volatility to emphasise the benefits of the approach.
This example is one of the occasions when phasing would have produced a better result. Ignoring reinvested income:
- £12,000 invested on 28 September 2018 would be worth £11,807 at 30 September 2019; but
- Phasing £1,000 a month for 12 months produces £12,364.
Adjusting for dividend and interest income would bring the numbers closer together (dividend yields are higher than cash returns), but still favour the phased approach. The more risk-averse investor would also have had fewer sleepless night in December 2018 (see the graph below), having invested only a quarter of their £12,000 rather than the entire amount at that point.
So for clients easily spooked by market volatility – or maybe those investing for shorter time frames – phased investing may help to allay some of their concerns.
Alistair Wilson is head of retail platform strategy at Zurich