‘Buy low, sell high’ is a popular statement in the financial world. While market timing is nearly impossible, it is evident that when markets go through a negative patch, investors tend to stay away from most risky assets, ignoring their investment objective at the outset. But what about cost averaging, a strategy used by long-term investors to take advantage of different market cycles in order to boost their investment returns?
Prior to investing, an investment advisor will help the investors to set up a personal financial roadmap and evaluate investment objectives and their risk tolerance. An important factor that an investor should consider is the risk against reward – the higher the risk, the higher the reward.
Although the reward will depend on the level of risk one is willing to take, it is important to remember that the end result of investing in financial markets is not always a positive outcome. However, through a good understanding of what you are invested in and the longer an investor remains invested, the higher the probability of positive long-term returns.
Following a thorough analysis of the assets to invest in, an investor decides on the frequency of the contributions and the sums to be contributed. A well-diversified investment fund or exchange traded fund (ETF) will be a suitable solution for such strategy, particularly if an investor wants to reduce specific risk of investing in a few bonds or shares.
Market declines should not put off investors from putting further money, given the strategy’s long-term nature. In fact, keeping in mind the spread of assets held in your investment fund, one should take the opportunity to reinvest their capital, at cheaper prices than originally purchased.
The investor purchases more shares when prices are low and fewer shares when prices are high. The principle is that cost averaging lowers the average cost of shares over time, which in turn increases the opportunity for an investor to make a profit over the long-term when equity markets, despite their inherent volatility, are expected to generate higher returns compared to both cash and bonds.
Overall benefits of cost averaging may not be evident in the short term
Therefore, one reason cost averaging is so attractive is that it forces the individual to invest no matter what the market is doing. This helps to avoid the poor decisions most people make when trying to time the market. When the stock market is decreasing, many investors become sceptic and thus reluctant to put more money into the market. This tactic may help avoid some losses in the short-term, but when markets recover, an investor who did not participate during a negative market period will lose out on the gains which usually follow a market sell-off.
However, those who invest a fixed amount every month will be in a much better position to benefit when the market bounces back. In other words, this strategy is not about market timing and being highly active, but being objective-oriented and consistent month-on-month.
American businessman and investor Warren Buffet once said: “We continue to make more money when snoring than when active.”
Many funds waive their required minimums for investors who set up automatic contribution plans. While small contributions may not seem impressive at first glance, they enable investors to get into the habit of investing. In addition the benefits of such a strategy will only be witnessed over the very long-term. The earlier an investor starts contributing towards their goal the better.
Let us take a factual example of an investor who either invested a lump sum or a monthly sum in the iShares S&P 500 ETF. As one can see in the above chart, the investor who invested a lump sum in this ETF in January 2008, generated a higher return. However, it is fair to argue that few are those investors who managed to stomach the negative effects of the 2008 financial crisis. Conversely, those who opted for a cost averaging strategy (dollar cost average) experienced a smoother performance throughout these 10 years.
Establishing a disciplined and regular investment pattern is an ideal strategy for an investor at any time. In doing this, the emotion and speculation is taken out of the investment process and returns will be smoother amid market volatility.
Moreover, the overall benefits of cost averaging may not be evident in the short term. Volatility may erode the benefits of cost averaging in the short run, especially in rising markets. But it is also fair to say that investors are also afraid to invest following a long period of positive performance and therefore drip feeding could be the solution. Therefore investors are likely to have more peace of mind through long-term investing, as they stand to gain from this strategy as they participate in all market conditions, as financial markets go through different cycles. Long-term investors do not shun market volatility, but make it work in their favour.
This article was prepared by Matthew Miceli Donnelly, ICIWM, B.Com (Melit.), B.Com (Hons) Management, MBA (Melit.), assistant investment advisor at Jesmond Mizzi Financial Advisors Ltd. This article does not intend to give investment advice and the contents therein should not be construed as such. The company is licensed to conduct investment services by the MFSA and is a member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information, contact Jesmond Mizzi Financial Advisors Ltd of 67, Level 3, South Street, Valletta, on 2122 4410, e-mail email@example.com or visit www.jesmondmizzi.com.
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