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.
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