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Making volatility work for you
15.03.2009

volatilityIn times of falling equity values the natural urge for many investors is to redirect regular investments to safer, less risky funds. But, for clients investing into regular savings plans, falling values may actually be a good thing over the medium to long-term.

The rule of thumb for investing is to buy when prices are low and sell when they are high.

An alternative approach to investing in volatile markets is through a regular savings plan. By investing a set amount at regular intervals you can drip feed your investment into the market- a strategy known as ‘unit cost averaging’.

Don’t let this complicated term confuse you as the principle is quite simple really. If the market does fall, then you know that your next monthly investment will benefit from purchasing a higher number of shares at a lower price. Of course, in a rising market, this will result in less shares being purchased but then your existing shares should be showing a profit.

No need to try and time the markets

This strategy helps to reduce the effects of market fluctuations over the medium to long term. It does this by not seeking to time the market, but rather you simply invest the same amount of money at, say, monthly intervals; the result is that you buy more units when the price is low and less when the investment fund price is high, thereby over the medium to long term averaging the price you pay and thus managing your risk. The averaging effect means that the risk of paying for all of the units at the highest price during the investment period is eliminated. Of course, as with any stock market based investment there remains a risk in that the value of your return can still fall or rise. However, Unit cost averaging is most effective at smoothing the impact of fluctuations when the unit price is volatile.

How does this work?

The diagram below shows how the share price of a theoretical investment (represented by the dots) can fluctuate over time. As can be seen from the bars, an investment of £100 per month buys a lower number of shares when the share price rises but a higher number of shares when the share price falls.

Another way to show this is in the diagram below, £1200 is invested over a 12-month period at a rate of £100 per month.

  • In month 1 the unit price is 100p and so the £100 investment buys 100 units.
  • In the subsequent 4 months the price of the units gradually falls and so more units are purchased for the £100 invested each month. As the unit price reaches its lowest point in month 5, the most units are purchased for any 1 month period.
  • From month 5 the unit price begins to rise reaching its highest point in month 10, where the least units are purchased for £100.

In this example regular monthly investing results in 46.5 more units being purchased than through a lump sum investment, because more units are purchased when the price is below 100p and less when the price is above 100p. Remember this is an example and such not be relied upon as an indicator of future performance.

The statistics show that over the medium to long term investment into asset backed investments such as shares produce the highest profit for an investor. By working with a financial adviser it is possible to participate in those returns and manage your risk. One such management tool is Unit Cost Averaging, a tool that helps you not only iron out the rises and the falls in the market, but can also benefit you, as the investor, during a temporary fall in the price of an investment. If you would like more information on this please contact your advisor who will be happy to discuss this with you further.


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