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Steve asks: I have recently opened my first Stocks ISA and spread it across five funds for this year’s allowance. I was contemplating transferring an existing cash ISA (about £70K) that is just about to mature as cash rates seem so poor. Is now a good time to be thinking of doing that? I read of corrections on the horizon, so I’m nervous about investing a large lump now. I intend to leave the money invested for five or more years.
Kyle Caldwell (pictured above), Collectives Editor, interactive investor, says: there has been plenty of speculation that a stock market correction could be on the cards. High up on investors’ ‘worry lists’ is the Covid-19 Delta variant, higher inflation being here to stay rather than transient, and the prospect of the Federal Reserve in the coming months beginning the process of unwinding its stimulus programme, so-called tapering (which has helped prop up asset prices – including stock markets).
In addition, a research report last month by Bank of America pointed out that over the past 90 years every economic recovery has had a substantial market sell-off in the first two years. To date this has not played out. As ever, while an interesting observation, comparisons with the past should always be taken with a pinch of salt.
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The reality is no-one knows when a stock market correction will play out. In addition, it is almost impossible to identify market peaks and troughs.
The thing to bear in mind is that some level of volatility is inevitable when investing in equities. It is the price investors pay for the fact that, over the long run, putting money into shares rather than leaving it in cash will potentially yield greater rewards.
Those who buy at the wrong time can end up nursing painful paper losses. The risk is that investors then lose their nerve and sell stock, resulting in the double-whammy of losses being crystallised, then missing out when markets recover their poise.
The sell-off in the first quarter of 2020 is a case in point. From peak to trough (21 February 2020 to 23 March 2020) the FTSE All Share Index declined by 33.6%. Therefore, an unlucky investor could have seen their investment pot fall by a third if they bought and sold at the two worst possible points.
The investor who held their nerve and kept the faith will now be back above water. As from 21 February 2020 to 7 September 2021 the FTSE All Share Index is up 5.1%.
A lucky investor, who timed their market entry perfectly when markets started to recover from 23 March 2020 onwards, will have pocketed a return of 58.2%. But the chance of pulling this off is pretty slim.
Ways to reduce risk
The reliable way for an investor to reduce the risk that they enter the market at a disadvantageous time is to drip-feed money into an investment on a monthly basis. A regular plan, involving investing at the start of every month, for example, does away with the risk that you might put all your cash into the market just before a nasty dip. Similar to household bills, you can set up a direct debit to take a specified amount out of your bank account every month. Regular investing is free on the interactive investor platform.
This strategy benefits from what is known as pound-cost averaging. When stock markets fall, the regular investment purchases more shares or fund units. Conversely, when stock markets rise, fewer shares and fund units are bought.
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Generally speaking, when markets are buoyant, lump-sum investing wins out over investing regularly on a monthly basis. Research by FundCalibre, for example, shows a £100 a month investment into a passive fund tracking the FTSE 100 in 2017 - a good year - would have ended up with £1,280.80 at the end of the year. Those who had invested £1,200 on the first day of the year as a lump sum would have ended the year with £1,343.40.
However, following the same process again in 2018, when the market fell over the year, would have resulted in a lump sum of £1,200 being reduced to £1,095.18, while monthly savings would have been worth £1,114.23. This is still a slight loss, but a little less painful.
Remember, though, that while investing a lump sum can in some situations be more profitable, it is substantially higher risk than drip-feeding your money into the market. Given that the regular investing approach guards your investments from rapid rises and falls in markets, it is a price that many investors are prepared to pay for peace of mind.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.