Investing in a falling market
In recent years investors have become accustomed to relatively benign market conditions. Last week’s market sell-off was an important reminder that this degree of stability is an abnormality, not the new norm.
We could be entering a period where we may experience more ‘normal’ levels of market volatility. During such periods investors often ask the question; should I continue to make regular contributions to my portfolio?
For investors whose objective is to maximise the long-term growth from their investments the answer is “Most definitely, yes!”
In fact, as counter-intuitive as it may seem, extended periods of market decline provide the ideal situation for long-term regular investors. The reason for this is that as markets decline, so do the unit prices of the investments being purchased. Effectively, more units can be acquired for the same amount of money. As long as the fluctuating markets' overall direction of growth is upwards, by continuing to invest regularly, over time you will earn more from your investments than if markets had steadily risen.
Set out below are three scenarios for three different investors, Tony, Ellie and Phil, who want to invest $1,000 per month for 10 years (i.e. a total investment of $120,000).
Tony's investment.
In this first scenario, Tony’s investment unit price rises at an average compounding rate of 5% per annum, so that a starting unit price of $1 grows at a consistent rate to finish at $1.64 by the end of the 10 years. In other words, this assumes that the unit price never falls - it just steadily rises. At the end of the 10 years Tony will have $155,266.
Ellie’s investment.
Normally markets don't steadily rise over a 10-year period - they go up and down (in a zigzag fashion). When averaged out over the long run, the data shows that the extent of 'ups' outweighs the 'downs', with the overall trend being upward. So, our second scenario looks at the end value of Ellie’s investment if the unit price zigzags its way up from year to year.
I have assumed that in years one, three, five, seven and nine the unit price falls by 5% per annum and in years two, four, six, eight and 10 the unit price rises by 15% per annum. The net result at the end of the 10 years is a unit price of $1.64, the same as in Tony’s case. This also produces an average return of 5% per annum over the 10-year period. However, in this scenario by the end of the 10th year, Ellie’s monthly investments will have grown to $162,235, nearly $7,000 more than Tony’s. This is even though the unit price in both instances started at $1 and ended at $1.64.
Ellie’s overall investment is worth more because each time the markets declined, she was able to acquire more units at a cheaper price. This provided Ellie with a greater total number of units at the end of the 10 years, which translated into a higher-value investment once the unit price recovered.
Phil's investment.
The third scenario considers a situation where the markets decline for an abnormally long period. I have assumed that Phil’s unit price drops 10% per year for the first five years and then rises by 20% per year for the following five years. The net effect of these movements is that the unit price starts at $1 and rises, once again, to $1.64 by the end of the 10th year. This equates to an average compound return of 5% per annum - exactly the same as for Tony and Ellie’s investments.
However, in this example the value of Phil’s investment rises to $228,702, which is a staggering $73,436 higher than Tony's investment and $66,467 more than Ellie's.
Even more interesting is that if the unit price only ever climbs back up to $1 (instead of $1.64) after 10 years, Phil’s investment will still have grown substantially to $154,726 - only $540 less than Tony’s. This is particularly interesting when one considers that the end unit price in this scenario is only $1, which is nearly 40% lower than in the first three examples.
The reason for Phil’s outcome is that by the end of year five, the unit price of his investment will have dropped to as low as $0.61, meaning that a $1,000 contribution buys 1,638 units. This is significantly more units than the 1,000 that Phil was able to purchase at a price of $1 per unit. By the time the unit price moves back up to $1, Phil owns significantly more units at a higher price, thereby providing him with a much higher-value investment.
These scenarios demonstrate that investors who make regular contributions to their investments will be far better off in the long run if they continue saving even when the markets are in decline. In fact, as difficult as it may be to stomach at the time, the greater the volatility over the short term, the better off investors will be in the long term when markets inevitably resume their long-term upward trend.
We could be entering a period where we may experience more ‘normal’ levels of market volatility. During such periods investors often ask the question; should I continue to make regular contributions to my portfolio?
For investors whose objective is to maximise the long-term growth from their investments the answer is “Most definitely, yes!”
In fact, as counter-intuitive as it may seem, extended periods of market decline provide the ideal situation for long-term regular investors. The reason for this is that as markets decline, so do the unit prices of the investments being purchased. Effectively, more units can be acquired for the same amount of money. As long as the fluctuating markets' overall direction of growth is upwards, by continuing to invest regularly, over time you will earn more from your investments than if markets had steadily risen.
Set out below are three scenarios for three different investors, Tony, Ellie and Phil, who want to invest $1,000 per month for 10 years (i.e. a total investment of $120,000).
Tony's investment.
In this first scenario, Tony’s investment unit price rises at an average compounding rate of 5% per annum, so that a starting unit price of $1 grows at a consistent rate to finish at $1.64 by the end of the 10 years. In other words, this assumes that the unit price never falls - it just steadily rises. At the end of the 10 years Tony will have $155,266.
Ellie’s investment.
Normally markets don't steadily rise over a 10-year period - they go up and down (in a zigzag fashion). When averaged out over the long run, the data shows that the extent of 'ups' outweighs the 'downs', with the overall trend being upward. So, our second scenario looks at the end value of Ellie’s investment if the unit price zigzags its way up from year to year.
I have assumed that in years one, three, five, seven and nine the unit price falls by 5% per annum and in years two, four, six, eight and 10 the unit price rises by 15% per annum. The net result at the end of the 10 years is a unit price of $1.64, the same as in Tony’s case. This also produces an average return of 5% per annum over the 10-year period. However, in this scenario by the end of the 10th year, Ellie’s monthly investments will have grown to $162,235, nearly $7,000 more than Tony’s. This is even though the unit price in both instances started at $1 and ended at $1.64.
Ellie’s overall investment is worth more because each time the markets declined, she was able to acquire more units at a cheaper price. This provided Ellie with a greater total number of units at the end of the 10 years, which translated into a higher-value investment once the unit price recovered.
Phil's investment.
The third scenario considers a situation where the markets decline for an abnormally long period. I have assumed that Phil’s unit price drops 10% per year for the first five years and then rises by 20% per year for the following five years. The net effect of these movements is that the unit price starts at $1 and rises, once again, to $1.64 by the end of the 10th year. This equates to an average compound return of 5% per annum - exactly the same as for Tony and Ellie’s investments.
However, in this example the value of Phil’s investment rises to $228,702, which is a staggering $73,436 higher than Tony's investment and $66,467 more than Ellie's.
Even more interesting is that if the unit price only ever climbs back up to $1 (instead of $1.64) after 10 years, Phil’s investment will still have grown substantially to $154,726 - only $540 less than Tony’s. This is particularly interesting when one considers that the end unit price in this scenario is only $1, which is nearly 40% lower than in the first three examples.
The reason for Phil’s outcome is that by the end of year five, the unit price of his investment will have dropped to as low as $0.61, meaning that a $1,000 contribution buys 1,638 units. This is significantly more units than the 1,000 that Phil was able to purchase at a price of $1 per unit. By the time the unit price moves back up to $1, Phil owns significantly more units at a higher price, thereby providing him with a much higher-value investment.
These scenarios demonstrate that investors who make regular contributions to their investments will be far better off in the long run if they continue saving even when the markets are in decline. In fact, as difficult as it may be to stomach at the time, the greater the volatility over the short term, the better off investors will be in the long term when markets inevitably resume their long-term upward trend.
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Peter Ashworth is a Principal of New Zealand Funds Management Limited, and is an Authorised Financial Adviser based in Dunedin. The opinions expressed in this column are his own and not necessarily those of NZ Funds. His disclosure statements are available on request and free of charge.
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First published in the Otago Daily Times on 12 August 2019, as ‘Investing in a falling market.’
