The danger in waiting for a market drop
The Global economy continues to be unpredictable, as numerous financial and political influences such as Trump and Brexit continue to unravel. Whether you’ve sold property, sold a business, received an inheritance, or simply had a good year at the office, one of the biggest dilemmas investors face is market timing; is now the right time?
Many will decide to hold off making an investment, especially with a larger lump sum, choosing to keep cash and see what happens. In the first instance it may appear sensible, but predicting short-term market movements is incredibly difficult, if not impossible. Sitting in cash with the anticipation of exploiting a drop can be a dangerous game.
Remember why you’re investing in the first place. It may be to provide income in retirement; a long-term consideration, where markets are expected to fluctuate over time. Your investments should be made in the context of a financial goal or aspiration, with an appropriate timescale taken in to account.
Volatility is inevitable, history demonstrates that, but it is important to make a distinction between market volatility and a market correction. A correction implies something has been repaired, unfortunately, it’s not the case. It is a sharp decrease in market value, at least 10% over a very short period of time. The last time we experienced a correction was in February, following a burst of aggressive growth. The market has since recovered, as we know to be the norm. Predicting this situation and exploiting it successfully will have been more luck than judgement!
We have experienced a nine year bull market since the financial crisis of 2007/08; whilst volatility should be expected, a significant correction is far from a certainty in the near future. When a correction does happen, the expected opportunity cost of lost growth anticipating the event is typically much higher than the expected benefit.
Where clients are particularly concerned about a drop in the market we seek to take advantage of Pound Cost Averaging, dripping money into the markets. Pound Cost Averaging is a technique that reduces exposure to falling markets from investing a lump sum in one go. By splitting a lump sum into regular, scheduled smaller contributions, more shares are purchased when prices are low and fewer when prices are high. We may, for example, recommend that these investors either feed funds from cash or from a lower risk portfolio over a set period which could be a few months or a year or two as opposed to just one payment.
A similar principle applies for regular savers.
Naturally, this will mean you will be worse off in rising markets, but much better off in falling markets. The effect of Pound Cost Averaging is a smoother return, mitigating volatility, whilst instilling financial discipline.
Holding cash, you may have potentially lost investment growth, but inflation will also erode the purchasing power. At the time of writing the Bank of England base interest rate was 0.75%, indicative of interest on cash holdings, whilst the inflation rate is 2.3% ensuring that you are worse off in real terms.
If you are intent on waiting for a correction, at what point do you invest? Having an arbitrary figure in mind of a 10% or 20% loss is one thing, but is that truly the ‘bottom’ of the market? It’s a dangerous game of constantly second-guessing an important decision.
Exacerbating this, you may have lost out on tax-efficient pension or ISA allowances. The bottom line is; the longer you stubbornly wait for a correction, the larger the opportunity lost.
A calculated risk
The right question isn’t when to invest, but what is your investment risk tolerance? An appropriately risk aligned portfolio, with regular reviews, should mitigate against unnecessary loss better than gambling with market timing.
Above all, when invested, try to avoid emotionally driven decisions when markets do fluctuate; stay the course. Those that do will ultimately reap the greatest rewards. One of the more famous Warren Buffett quotes; “If you aren’t thinking about owning a stock for 10 years, don’t even think about owning it for 10 minutes.”