Independent on Sunday

[ August 31, 1999 ]

The following is an extract from last week's regular feature in the Personal Finance section of the Independent On Sunday. Be sure to pick up your copy this Sunday.

Bang for your Buck

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 FTSE 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% 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.

Now, if you have just started your regular contributions to your tracker fund, how do you think you are going to feel if the FTSE 100 starts falling, which it inevitably will sometimes? Will you curse your luck for starting to invest at bad time? If you are Foolish, and are investing for the long term, you shouldn't feel bad at all. In fact, you should actually feel rather good about it.

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? Would you want hamburgers to become cheaper, or more expensive? That's a pretty easy one, but does it apply to shares too? The comparison doesn't really work over the long term -- 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 when the time comes to retire and buy that yacht. But it makes 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? It really doesn't help you at all if the prices of shares are rising and your haven't had time to buy many of them yet.

Lets have a look at a quick example. Suppose a company's shares are selling for £10, and you invest £100 one month, getting you 10 shares. Then there is a huge market crash and the price falls by 50% to £5. Next month, you invest your next £100, and this time you get 20 shares for the same money. A bargain, don't you think? 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? The instinctive answer, and the answer most people would immediately give, is £7.50, half way between the two prices you have paid. But that's not actually correct. Remember, you got twice as many shares at the lower price, so you need to divide the total price paid for all your shares by the number of shares you have bought. That's £200 divided by 30, for an average price of £6.67, which is certainly better than £7.50.

Now, by the time your next month's investment comes around, the market, as markets have always always done over the whole of this century, recovers. Your favourite share price is back to £10 again. This time, you get your 10 shares, giving you a total of 40, and costing a grand total of £300. Your average share price, £300 divided by 40, is now £7.50 and the shares are worth £10. Congratulations, you are sitting on a profit of £2.50 per share, or 33%, and that is an effect known as pound-cost averaging. Your £300 has turned into £400. And all because there had been a market crash. If the crash hadn't happened, and the share price had remained at £10 all along, you'd have no profit yet.

OK, so markets don't often crash by 50%, and they certainly don't fall that far one month to recover the next month, but markets do go up and down. And 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.

We were also, of course, using shares in a company as our example, but you wouldn't directly buy £100 worth of shares each month, as the dealing charges would be far too high. No, but exactly the same thing applies to a tracker fund too. These funds are priced in units (the fund equivalent of shares), and when the value of these falls, you get to buy more of them, just as you would with company shares.

So, 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 actually increase our eventual long-term profits, not decrease them. That thought should help you to sleep better at night, don't you think?

My Dumbest Investment

Early last year, I bought shares in nightclub operator Northern Leisure at 250p per share. The share price then went into free fall, and I couldn't really understand why. I watched them fall all the way to 119p before I lost my bottle and sold out, and I felt smug when they fell further, to 83p. Since then they have recovered to over 180p. Selling at 120p seems like a dumb move now -- SG, Liverpool

The Fool responds: It is very easy to panic and sell shares when we see the price fall and we don't understand the reason. What Fools should do is evaluate the company again, and sell if there is something fundamentally wrong. If you can find nothing wrong, why not consider buying some more at the new bargain price instead?

Ask the Fool

Why is it that some people like to buy shares with high P/E ratios, and some like them low? Which is best? -- MM, Swansea

The Fool responds: A company's Price to Earnings ratio is actually pretty meaningless on its own. Its future prospects need to be examined too. On the Fool website, we have a series on how to value shares, which you might find useful.

Foolish Trivia

Which company, which was caught pulling the rug over its sales figures last year, saw its shares lifted off the floor last week thanks to takeover talk? (Last week's answer: Rentokil Initial)