Disclaimer: As with all investing, financial instruments involve inherent risks, including loss of capital, market fluctuations and liquidity risk. Past performance is no guarantee of future results. This information is for educational purposes only and should not be considered as personalised investment advice. It is important to consider your risk tolerance and investment objectives before proceeding with any investments. A pension may not be right for everyone. Tax treatment depends on your individual circumstances and may be subject to change in the future. If you are unsure investing is the right choice for you, please seek financial advice.
It’s certainly been an exciting few weeks in the markets where we have seen huge swings in asset values attributed to fears over an impending US recession, fallout over the Japanese yen carry trade, and shifting expectations over interest rate cuts. Our portfolios are designed to help cushion the blow of significant fluctuations to your savings and have done so to good effect, but we are nonetheless not immune to wider market trends. The quick market recovery is a great example of the non-linear path investments hold.
Investing can be emotionally testing at times, especially when market volatility leads to unexpected gains or losses. It’s very much a natural response to feel nervous or anxious when things are on a downwards trend. That being said, however, there will always be an element of short-term uncertainty on an investment journey so it’s important to put things into a broader perspective. Through this piece I’ll look to explore how a well-structured investment plan can help yield a positive outcome for retirement savings.
Navigating an uncertain climate
Often in a negative market, investors who do well drip feed a larger sum of money as regular contributions over a longer period of time. This is known as pound cost averaging (PCA). What this can help to do is lower the average cost per unit as markets fall, with consistent and frequent contributions going into your pension when asset prices fall, buying more units at a lower price. We can take a look at an example below of two investors over the course of one year, one putting a lump sum at the start of the year and one spreading the sum of their investment out evenly each month:
This is not a case study using real market data, but in the example here we see that the investment never reaches its original value of £100, seeing a decline until July before picking up towards the end of the year. Both investors contributed the same amount (£12,000) but had two very different outcomes.
Investor A bought the investment at its highest value and was then subject to the entirety of the market fluctuations; Investor B split the sum of their investments up into even instalments over the course of the 12 months, buying at lower and sometimes higher prices. Not only did Investor B end up with more units of the investment than Investor A, but they also saw a higher level of return in doing so because they bought in at a lower starting point only for performance to then pick up.
While this is a simplified example, it hopefully illustrates the power of PCA. When markets decline, your investment buys more units at a lower price compared to when markets are rising. The longer your investment horizon before retirement, the better it is to buy whilst things are cheaper, allowing plenty of time for markets to recover and grow and ultimately strengthening your pension pot.
If you are nervous about your retirement savings when there is a downturn then PCA can be a powerful tool for mitigating the emotional risk of making irrational decisions. We are twice as likely to feel the impact of negative news more strongly than we do positive, and what we tend to see during these periods is that investors sell at market lows having previously bought in at a high point, allowing fear to overpower logic.
Since pensions generally cannot be accessed early – except in extreme cases – people often respond to tough climates by stopping contributions, rather than maintaining a consistent strategy. PCA helps counteract this natural tendency whilst, at the same time, encouraging disciplined saving habits by automating the investment process.
Regular contributions can help counteract this natural emotional instinct, reducing the need for intervention and helps prevent decisions that could undermine your retirement goals. By ensuring consistent contributions over time, PCA also guards against the biases of lump-sum investments in the short term which can be vulnerable to market timing.
The case for lump sum investing
This is not to say that lump sum investing doesn’t have its place in retirement planning. Depending on how far off you are from retirement, as a rule it’s the time which you spend in the market, as opposed to timing the market, which makes all the difference. Below I’ve set out the performance of an S&P 500 ETF (IE00BM67HX07) over two- and five- year periods, both of which include examples where people have contributed a singular lump sum or PCA.
In the first chart we see two investors contributing £12,000 from the start of 2022 until the end of 2023, whilst in the second chart we see two investors contributing £60,000 from the start of 2019 until the end of 2022.
In the two-year performance, we saw pound-cost averaging (PCA) successfully achieve returns greater than the £12,000 contribution, despite market conditions leaving the lump sum investment below that threshold two years later. 2022 was one of the worst years in history, and even a strong recovery the following year couldn’t fully offset the impact of the sell-off. What this tells us is that investing a lump sum creates higher risk in the short term when markets are choppy, as the entire amount is exposed to volatility from the outset. However, steady contributions over a shorter time frame meant that not the entire sum was subjected to these downturns, and in this example, buying the investment at lower prices resulted in positive performance.
In the chart showcasing 5 year performance, a longer investment time horizon, it shows the benefits of staying in the market as opposed to regular contributions. Despite £60,000 being invested in each case, the example of someone paying in the lump sum meant they were £33,742.39 better off than the one who drip fed for the duration.
It’s worth bearing in mind that history shows that 73% of years are positive vs 27% negative*, so for people with a longer time horizon, choosing to drip feed can mean that you are leaving a lot of your money on the sidelines when it could be earning you a return.
How should I plan for my retirement as a result?
There’s no guarantee that PCA will benefit retirement savers for the long-term, but it can be invaluable for easing the stress of market volatility. In a rising market though it can be hugely beneficial to have as much capital invested as early as possible to capitalise on lower prices from the outset. That being said, even the best money managers find it difficult to time the market effectively, so letting the market work for you over the long term is not a bad play.
Your retirement strategy should depend on your investment horizon, as well as your tolerance and appetite for risk. With a long way off retirement, the risk of being unlucky with the market can be lower as you have ample time to benefit from both economic and asset growth.
However, if you have a shorter horizon, you may need to be more agile and consider a more conservative contribution strategy to avoid the bias of lump sum investing. Equally, your cash needs are an important consideration; if you don’t have large sums readily available, balancing your contributions between short, medium, and long-term savings goals, including your pension, can help secure many aspects of your financial security, especially while prices are lower than they will likely be in the years to come. Seeking professional guidance with one of our Investment Consultants can help to ensure that you’re on the right track.
*Source: S&P 500 total historical performance.
*Capital at risk. Tax treatment depends on your individual circumstances and may be subject to change in the future.
