The Latest News From The Motley Fool: Dance with the bears

The Motley Fool started as an irreverent investment newsletter and has grown to become one of the most popular personal finance and investment websites. Anyone who follows its philosophy is called a 'Foolish investor'.

This week, let's switch off the markets for a while, forget about how our favourite companies are faring, and have a look at some good old Foolish basics.

Most people who start investing do not have large lump sums available, and need to fund their investments from regular monthly savings instead. One way of doing this, and one which is greatly favoured in Foolish circles, is by the use of an index-tracker fund.

An index-tracker is a fund which simply spreads its money across the whole of the index in question, the FT-SE 100 for example, and gives a long-term return very close to the actual index itself. By simply doing this, index-trackers beat about 90 per cent of all actively managed funds. But tracker funds themselves are not the subject for today.

Today we are going to talk about pound-cost averaging.

If you have just started your regular contributions to your tracker fund, how do you think you are going to feel if the FT-SE 100 starts falling? If you are Foolish, and are investing for the long term, you should not feel bad at all.

Warren Buffett, probably the world's best-ever investor, likes to compare the long-term buying of shares with hamburgers. If you plan to be buying hamburgers every week for the next 30 years, which way should you want the prices to move over the coming weeks and months?

That's an easy one: you would never actually want the price of hamburgers to rise again, no matter how long you wait. But you do want your shares to have grown in value by the time you come to retire and buy your yacht.

However, falling values make pretty good sense in the shorter term. If you are a net buyer of shares, and you won't want to be selling any for at least a couple of decades, shouldn't you want the prices to fall so that you can get more for your money next month?

Suppose a company's shares are selling for pounds 10, and you invest pounds 100 one month, getting you 10 shares. Then there is a market crash and the price falls 50 per cent to pounds 5. Next month, you invest your next pounds 100, and this time you get 20 shares for the same money. You now have 30 shares, where you would only have had 20 if the price hadn't fallen. And what was your average purchase price for your shares? You need to divide the total price paid for all your shares by the number of shares you have bought. That's pounds 200 divided by 30, for an average price of pounds 6.67.

Now, by the time your next month's investment comes around, our favourite share price is back to pounds 10 again. This time, you get your 10 shares, giving you a total of 40, and costing pounds 300. Your average share price is now pounds 7.50 and the shares are worth pounds 10.

Congratulations, you are sitting on a profit of pounds 2.50 per share and that is an effect known as pound-cost averaging. Your pounds 300 has turned into pounds 400.

Okay, so markets don't often crash 50 per cent and recover the next month, but when they're down, you get better bargains. Over the decades that Foolish investors are interested in, markets rise, no matter what short-term fluctuations there are in the meantime.

The inescapable conclusion for Foolish investors who believe that stock markets will rise over the long term is that we should invest our money regularly on a steady pound-cost basis. Short-term falls will increase our eventual long-term profits, not decrease them.

n Motley Fool: www.fool.co.uk

Start your day with The Independent, sign up for daily news emails
ebooks
ebooksA special investigation by Andy McSmith
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE £45,000: SThree: SThree Group have been well e...

Ashdown Group: IT Manager / Development Manager - NW London - £58k + 15% bonus

£50000 - £667000 per annum + excellent benefits : Ashdown Group: IT Manager / ...

Recruitment Genius: Sales Consultant / Telemarketer - OTE £20,000

£13000 - £20000 per annum: Recruitment Genius: Scotland's leading life insuran...

Ashdown Group: Training Programme Manager - City, London

£40000 - £45000 per annum + benefits : Ashdown Group: Training Programme Manag...

Day In a Page

Where the spooks get their coffee fix: The busiest Starbucks in the US is also the most secretive

The secret CIA Starbucks

The coffee shop is deep inside the agency's forested Virginia compound
Revealed: How the Establishment closed ranks over fallout from Loch Ness Monster 'sighting'

How the Establishment closed ranks over fallout from Nessie 'sighting'

The Natural History Museum's chief scientist was dismissed for declaring he had found the monster
One million Britons using food banks, according to Trussell Trust

One million Britons using food banks

Huge surge in number of families dependent on emergency food aid
Excavation at Italian cafe to fix rising damp unearths 2,500 years of history in 3,000 amazing objects

2,500 years of history in 3,000 amazing objects

Excavation at Italian cafe to fix rising damp unearths trove
The Hubble Space Telescope's amazing journey, 25 years on

The Hubble Space Telescope's amazing journey 25 years on

The space telescope was seen as a costly flop on its first release
Did Conservative peer Lord Ashcroft quit the House of Lords to become a non-dom?

Did Lord Ashcroft quit the House of Lords to become a non-dom?

A document seen by The Independent shows that a week after he resigned from the Lords he sold 350,000 shares in an American company - netting him $11.2m
Apple's ethnic emojis are being used to make racist comments on social media

Ethnic emojis used in racist comments

They were intended to promote harmony, but have achieved the opposite
Sir Kenneth Branagh interview: 'My bones are in the theatre'

Sir Kenneth Branagh: 'My bones are in the theatre'

The actor-turned-director’s new company will stage five plays from October – including works by Shakespeare and John Osborne
The sloth is now the face (and furry body) of three big advertising campaigns

The sloth is the face of three ad campaigns

Priya Elan discovers why slow and sleepy wins the race for brands in need of a new image
How to run a restaurant: As two newbies discovered, there's more to it than good food

How to run a restaurant

As two newbies discovered, there's more to it than good food
Record Store Day: Remembering an era when buying and selling discs were labours of love

Record Store Day: The vinyl countdown

For Lois Pryce, working in a record shop was a dream job - until the bean counters ruined it
Usher, Mary J Blige and Will.i.am to give free concert as part of the Global Poverty Project

Mary J Blige and Will.i.am to give free concert

The concert in Washington is part of the Global Citizen project, which aims to encourage young people to donate to charity
10 best tote bags

Accessorise with a stylish shopper this spring: 10 best tote bags

We find carriers with room for all your essentials (and a bit more)
Paul Scholes column: I hear Manchester City are closing on Pep Guardiola for next summer – but I'd also love to see Jürgen Klopp managing in England

Paul Scholes column

I hear Manchester City are closing on Pep Guardiola for next summer – but I'd also love to see Jürgen Klopp managing in England
Jessica Ennis-Hill: 'I just want to give it my best shot'

Jessica Ennis-Hill: 'I just want to give it my best shot'

The heptathlete has gone from the toast of the nation to being a sleep-deprived mum - but she’s ready to compete again. She just doesn't know how well she'll do...