Lumps, bumps and buying on the dip

Well it’s been an exciting few days in global stock markets – if rollercoasters are you entertainment of choice, that is. If you’re not so keen then you would be forgiven for replacing the word ‘exciting’ with ‘worrying’. It’s never nice to see your investments fall in value. Even less so, when they drop by 10% seemingly overnight.

Yes, Chinese growth is slowing, but that isn’t news. Yes, the Federal Reserve is still dithering over raising interest rates (I bet they are now kicking themselves for not taking the plunge at the start of the year) but what else has changed? Nothing really.

But rather than umming and ahhing and trying to second guess whether markets will continue their downward trajectory or bounce back with vigour, I thought I’d take a look at different investment strategies and how they can be used to mitigate or even take advantage of market volatility: lump sums vs monthly savings vs buying on the dips.

Many of us invest with lump sums – usually a few days before the end of the tax year and in a rush. Investing in this way means that you immediately have a lot of money exposed to the market, which can be good or bad in the short term!

Others prefer to invest monthly, enjoying the regular discipline and not even attempting to try to time the market, making the most of pound cost averaging (buying more shares when prices are falling and less when they are rising). Investing in this way tends to smooth out a lot of the market volatility, particularly when you first start saving and your pot of money is relatively small.

Commentators, including myself, talk about there being more value in the market and that, for the brave, volatility is perhaps a buying opportunity. Rather than risking a large lump sum when markets could go in either direction, however, there is a more disciplined way to do this – buying on the dips.

The nice people at Rathbones ran some data for me, showing the three different ways of investing £10,000 over the past 10 years. The results are illustrated in the graph and outlined below*:

Investing the whole lot as a lump sum, as you can see on the graph below, has led to some sharp falls in value. However, over the whole decade, the value of the investment has risen to £16,777.

Investing the same amount monthly has been a much smoother ride but the peace of mind has meant slightly lower returns: £13,151.

Investing £4,500 initially, then investing a further £500 each time the market fell by 5% or more in a day would have resulted in returns of £17,969.

Now, of course, a different 10-year period may lead to different results. Indeed, when Rathbones first ran the numbers for me in 2012, the lump sum method resulted in better gains than buying on the dips. However, the data demonstrates two things in my view. The first is that volatility isn’t necessarily a bad thing and the second is that, no matter which way we decide to invest, over the long term, if we hold our nerve, we are rewarded.

*Source: Rathbones, 19/08/2005 to 21/08/2015