In my previous article I mentioned the three principles of Consistency, Discipline and Patience as being key to a successful long term investing strategy that has stood the test of time and is likely to give you positive returns in the future.
Just as a recap, the whole purpose of these three principles is to get you away from the temptation of "timing the market" where you are effectively trying to find a "better moment" in order to squeeze out a little bit more profit. Usually this ends in failure and you're more likely to lose profits in the long run as opposed to making it, and even if you did manage to make a little extra profit it probably wouldn't have been worth the psychological turmoil.
That being said, it can indeed sound a bit strange (especially if you're new to investing) to hear that you should keep investing your money at the same rate and with the same frequency, and keep it invested no matter what happens in the stock markets. Notably, this means even if the market is falling in value or if the market is making new highs.
Why is it strange; well, isn't the aim of investing to buy at a low price and then sell at a higher price, rather than buy at any price no matter what?
In general, yes, but what is considered a high price today may not be the case if you look ahead to the future. Take a look at the following chart and table for the S&P 500 index over the past 140 years:
The data in this table shows the price of the S&P 500 index on the 1st January of each decade dating back to 1880. I have chosen to use this index as it is closely followed by almost all investors and represents 500 of the largest companies in the United States. Since the US is the biggest economy in the world, by investing in this index it is considered a very safe and stable move in the long run.
The 10 year difference column shows if the price has risen or fallen over the past decade. What you will see is that only three out of fifteen decades experienced a fall in value. Furthermore, two out of three "negative decades" were also the periods in which World War I and World War II happened.
If you extend the time frame to see the difference over 20 years, a decrease in overall value only happens once. This occurrence is in 1950 meaning you invested your money on 1st January 1930. Considering World War II happened during this time frame, it’s not the worst thing to be left with $16.88 after investing $21.71. Here's the really interesting thing, by the start of 1960 you would have recovered all of your investments (as long as you stay invested in the market) and in fact, you would have more than tripled your money.
This data also takes into account all of the market crashes that would have happened since 1880 meaning it includes the 1929 Wall Street Crash, Black Monday the 2nd in 1987, the Dot com bubble of 2000 and the housing market bubble of 2008. It would have been better if the decade ending in 2010 wasn't in the red as I could then say that it basically takes a World War to cause a "negative decade" but I can't have it all I guess. Still, it seems as though the market holds up pretty well against adverse conditions in the long run.
So as you can see, what might be considered a high price today may not be considered a high price in the future. In the 1940’s you would have been cursing the investment you made back in 1930, but by 1960 you would’ve wished you bought more. In fact, you’d probably happily pay double the price on what you originally paid since you’d still be in profit.
And if in 1960 you felt like the price of the stock market was too high because it had more than tripled in the past decade, you’d regret not buying more by the time 1970 came around.
Do you see why following the three principles is so important now?
If you kept on trying to time your investments based on what the market was doing, or if you had abandoned investing altogether because of some temporary bad results, you would have missed out on all of the growth that follows. You would have made a short term decision that resulted in a long term mistake.
Unit Cost Averaging
By being consistent and buying in regular intervals over the long term, you will buy when the financial markets are high and when they are low. This inevitably means you will sometimes buy just before the market drops and there's almost no avoiding it (unless you get really lucky). But if you are buying consistently at regular intervals you will actually be in the market at an average price level that is most likely lower than the price of the market itself, even after it drops.
This is known as Unit Cost Averaging.
Take a look at the following example where you are investing £300 each month for a year to buy units of the stock market. As with any investment the value will fluctuate over short time frames.
For each month where you invest £300 into the stock markets you will buy a certain amount of units depending on how much each unit costs. In January, as the unit price is a nice even £30 you are able to buy 10 units (£300 ÷ £30).
In February, as the unit price has risen you will get less number of units for your £300 because it costs you more money to buy each unit. Likewise, when the price drops in some of the later months you are able to get more for your money. The price fluctuates throughout the year but no matter what happens you will keep investing £300 right on schedule.
Now look at December where the price has risen quite a lot from January. This might be a situation where you are worried that the price is too high for you to buy.
But with Unit Cost Averaging it will make it easier for you to stay consistent, even in this situation with the higher price, because in the bigger picture your average price paid for each unit you own will be spread evenly. After making your investment in December you can work out your average cost per unit as follows:
Total amount invested: £3,600
Total units bought: 115.48
Average cost per unit: £31.18
(£3,600 ÷ 115.48)
Even after you’ve paid £42 per unit in December, when you average it out you will actually be in the market at £31.18 for each unit you own, a price that is far below the current level of the market. So even if the market drops by something quite big like 20% your overall investment would still be in profit.
This is the advantage of Unit Cost Averaging, it allows you to spread your risk by being consistent and regular with your investments. By doing this you are able to invest relatively large amounts of your money without feeling like you’re jumping all in at once. This in turn allows you to stay disciplined and patient, allowing you to maximise the full benefits of being invested into the stock markets for a long period of time.
Let's do another experiment using the S&P 500 data between 1930 and 1940. This is a decade where if you had invested all your money on January 1st 1930 and then never invested again, your investment would have fallen in value by 43.34% when you looked at it on January 1st 1940. The experiment is to see if Unit Cost Averaging would have made the decade profitable overall.
Here’s the table with the data:
The data is in US dollars because the S&P index is denominated in that currency.
Using the Unit Cost Averaging strategy you would have invested $300 each year for a total of $3,300 (inclusive of January 1st 1940). By the time the decade has come to an end this would have allowed you to buy 285.68 units. Here’s the maths to calculate the average cost per unit:
Total amount invested: $3,300
Total units bought: 285.68
Average cost per unit: $11.55
(£3,300 ÷ 285.68)
With the S&P 500 price being at $12.30 per unit and your investments being at an average cost of $11.55 per unit it means you would be in profit overall. Your investment value would be at $3,513.86 giving you a total profit of $213.86 and a performance of around 6.48%.
Total units owned: 285.68
Price per unit: $12.30
Total investment value: $3,513.86
(285.68 x $12.30)
($3,513.86 - $3,300)
(213.86 ÷ 3,300) x 100
Much better than taking a loss for the decade I would say.
There are some caveats to this example however; the intention of this example isn’t to decide whether or not Unit Cost Averaging is a better strategy compared to a single lump sum at the start. Depending on which year or decade you choose you will get different results on which strategy comes out ahead.
The key point of this example is to show that by staying consistent, disciplined and patient you can weather all sorts of conditions and come out stronger on the other end. The most important thing is to take a long term view and to stay invested no matter what happens.
If you simply follow that one rule, you will most likely always end up a wealthier person overall.
What if the market performs worse from this point onward?
In all of my examples (for this article or any others that I write) you will often see me use 7% as the average annual returns for a diversified investment portfolio that tracks the index. The number is based on a historical average and can be considered a fair number to use for a general forecast into future performance.
But there’s probably one question you’ve been asking:
What if it performs below average from now on?
This is a valid concern because if the performance suddenly drops and stays that way into the long term does that mean all of the examples I present are null and void?
To alleviate some of your concern I've put together a table that shows how your investments would perform if you invest £300 a month for a period of 40 years, and you experience a couple of decades where the returns are lower than average:
At the end of 40 years you would have invested a total of £144,000 from your own pocket. If you look at the amount you would have in the 4% column you will notice that you would still have more than doubled your money (£355.770.36).
Considering the 7% average annual returns actually takes into account the effects of inflation, the market would need to under perform quite considerably for a really extended amount of time in order for you to really feel the effects. Yes, it could happen; but we're all most likely in some great economic trouble if that were the case and even more so if you weren't making smart financial decisions such as investing for the long term.
What's worse than Timing the Market?
Another situation you might be concerned about is experiencing your first big drop in the stock markets, something that will inevitably happen if you’re going to stick to the rules and stay patient over the long term. The worst case scenario would be a big market crash right after you’ve just made your first step into investing.
There's actually an interesting investing story about this that you could look up by searching for:
"Bob, the worst market timer ever"
In summary the story talks about an investor named Bob who decides to follow a saving plan for himself. His plan was to save £2,000 each year during the 1970’s, then increase his yearly saving amount by £2,000 each decade. So in the 1980’s he will save £4,000 a year, £6,000 a year in the 1990’s and so on.
As he saves and builds up his money, Bob will try to time the market in order to invest all of his savings. He only ever makes four investments into the S&P 500 index throughout his life. The four times he invested was:
£6,000 in December 1972
£46,000 in August 1987
£68,000 in December 1999
£64,000 in October 2007
Coincidentally each time he invested his money it would be right before a major stock market crash. Essentially, Bob has the worst timing ever and got hit by a big market decline right after investing some of his hard earned money.
This is an investors worst nightmare and probably among the biggest fears for new investors looking to get into the market. However, Bob is patient and stays with his savings plan and investments all the way through to the end until he retires in 2013. When he checks his investment portfolio’s value after retiring he will discover that he has over £1.1 million. This is a profit of over £900,000 on top of the £184,000 that he put in himself.
Not bad for someone who has the worst stock market timing ever.
The point of this story is to tell you that even if you had been unlucky enough to invest your money into the markets before each major market crash in the past few decades, as long as you stayed patient and stayed invested you would have ended up making money in the long run.
So it turns out that trying to time the market isn’t actually the worst thing you can do. Using Bob’s story the worst thing you can actually do is not being invested in the stock market at all. Bad timing in the market is still better than no time in the market.
By looking at the long term history of the S&P 500 index it is reasonable to feel confident that over the span of a decade or two, chances are the price of a single unit will be worth more than it was in the past. This becomes even more the case as you extend that time frame out further.
If you had today's knowledge and someone offered you a chance to buy the S&P 500 index at a price of $282.70 on the 19th October 1987, would you take it?
Of course you would, the index is currently sitting at over $3,400 as I'm writing this article. You'd be making 12 times your money. But do you know the significance of that price and date?
It was the peak of the S&P 500 index right before it experienced it's largest drop in value in a single day (-20.4%). Sometimes I do wonder if there's any absolute hero from that day who still holds their investments after all this time, it's only been just over 3 decades after all.
But back on track; this just shows that it doesn't matter what the price is right now and what the market might do tomorrow, next week, next month or even next year. What matters is what the price will probably be in a decade's time or more, and the chances are it'll probably be higher.
At that point you'll consider the price of the market today, whatever it might be, to be "low" and you'll wish you had bought more (Note, don't invest more than what you can handle).
If you're concerned about market crashes happening just at the most inconvenient moments for you, think back to Bob's story. It’s possible that you have timing just as bad as Bob’s but it is almost impossible for you to have worse timing since he got hit by pretty much every major market crash that happened.
And don't forget about the benefits of Unit Cost Averaging. If you follow a plan of being consistent, disciplined and patient then you are most likely going to do better than Bob as you will not only invest during all the bad moments, but also during all the good moments.
In fact, if Bob had followed a strategy of investing a regular amount each month based on how much he was saving each year, his performance would have more than doubled in the same time frame and he would have an amount of £2.3 million in investments.
At the end of the day, nobody can guarantee what the financial markets will do in the future. Average annual performance may not be as good as in the past or you might be unfortunate enough to get hit by some big market crashes as soon as you invest your money. But as you can see from the earlier table illustrating below average performance figures, and from the example of Bob, the risk to your money over the long term is not as high as you may feel provided you are making sensible and well diversified investments.
My mission is to help people understand their money by making financial scenarios or concepts easy to understand.
If you found this post helpful, please share it with someone that you want to help.
Subscribe on the home page to stay updated for new posts.