Invest in the stock market, one drip at a time

Why regular saving is more effective than lump sum investing

Investing is simple: buy low and sell high, no? If only it were that straightforward. In practice, most people find it incredibly difficult to buy when prices are low and are more likely to sell at these times. Cash is a terrible long-term asset, paying virtually nothing and certain to depreciate in value. Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Government policies to alleviate the current crisis will probably prove inflationary and therefore accelerate declines in the real value of cash accounts.

What to do?

This ‘inflation tax’ should lead to cash moving into real assets to protect spending power.  Nonetheless, many investors are understandably hesitant to invest in an environment where the flow of economic news is relentlessly negative. Investors holding cash are betting they can efficiently time their investments later; however, it is likely that the market will move higher – perhaps substantially – well before either sentiment or the economy improves.

This creates a paradox. We generally buy more when goods and services become cheaper, and sell them only when it is profitable to do so. However, the reverse is quite often true with investments. Buying only after prices have risen and selling when you have lost money usually leads to disappointing results.

By deferring investments until it feels safe, you are likely to buy at substantially higher prices than today. Invariably, the time to buy stocks is when inflation is high and the economy is stuttering. In short, bad news is an investor’s best friend. It lets you buy a slice of an economy’s future at a marked-down price.

It is impossible to predict the short-term movements of the stock market, however: over the long term, stock markets rise strongly in value despite traumatic and expensive military conflicts, recessions, financial panics, oil shocks and epidemic fears. While holding cash feels comfortable, it shouldn’t.

A less stressful way to invest

When global stock markets lack overriding direction – as is the case currently – and are subject to wild swings, regular saving is the best way to counteract the bumps.

A key danger in a timing strategy is that investors will be out of the market when it rallies. Unless they have a sound, proven rules-based strategy, those who try to time their investments to avoid losses are likely to miss out on gains when markets rise.

A more effective strategy is to buy into a falling market over a period of time. By putting new money to work at intervals, investors can avoid the trap of trying to time the market, especially in a sell-off.

The process of drip-feeding investments is known as cost averaging. This method means savers are not obliged to time their entry and exit from the market. When share prices tumble, their regular saving buys more. When prices rise, their investment grows. Apart from benefitting from the smoothing factor, regular saving is a painless way of generating long-term capital growth.

This cost averaging reduces risk compared to investing a lump sum, and typically beats going to cash in difficult times.

The example below demonstrates that it is possible to make decent returns even when markets have been range-bound, as has been the case of the past 15 years.

Cost averaging: an example

Month                 Investment        Unit price           Units bought

January                €600                      50.00                     1.24

February             €600                      50.90                     1.22

March                  €600                      55.00                     1.13

April                     €600                      51.70                     1.20

May                      €600                      50.40                     1.23

June                      €600                      48.10                    1.29

July                       €600                      43.40                     1.43

August                 €600                      41.90                     1.48

September         €600                      38.30                     1.62

October               €600                      42.90                     1.44

November          €600                      45.60                     1.36

December           €600                      50.20                     1.23

After one year  €7,200                  50.20                     15.87

Total value                        €7,960

Performance                    7.06%

In this example, a profit of 7.06% has been made even though the value of the units has hardly changed at the end of the investment period compared to the price when the first investment was made.