We often pour lots of effort into thinking about financial decisions. Whilst coming up with a complicated and convoluted plan might feel like you are giving yourself an edge, in reality that isn’t always the case. (See ‘complexity bias’- perhaps a topic for a future article)
One of the most powerful & simple things investors can do is to use compounding to their advantage. This strategy can significantly help you in building wealth, in 3 key ways:
1) Little & often is much better than big & infrequent
2) Pound-cost averaging
3) Habits remove emotion
The first point above is a crucial one to understand, best illustrated with an example. Let’s assume that 10 years ago (May 2011) an investor started buying £2,000 worth of shares in a global equity tracker fund every month. What we are looking to achieve here is to get compounding working for us and to buy shares both in good times and bad, hopefully ending up with an investment that shows a meaningful profit over time.
The blue line is the price of the tracker, starting at around £18.70 at the outset and ending at its current value of £57.15. The orange line is the average purchase price our imaginary investor has paid for the shares. The grey line is the total theoretical value of the holding (right hand scale). Buying shares at £18.70 at the start was useful and the regular buying allows our investor to build their investment slowly from 2011 to 2012, when markets were relatively stagnant and prices low, compared to where they are now.
Markets really begin to rise in late 2013, by which point our investor has built their holding to around £75,000 of value and an average cost of around £20 per share. When the rally comes, those early purchases provide a great foundation to build on. As markets rise, we keep buying shares at our regular pace. When markets get choppy in 2018, our investor may barely feel it. Their average cost for the shares is approximately £25 and the market price is in the region of £44, before falling to £38. Even in the depths of 2020’s brutal, sharp bear market, our investor can take some comfort in that their average purchase price is £27 per share, versus the market’s low of £40 per share.
The end result is that our investor builds up a holding worth some £467,129 at current prices, for a total investment of £240,000. Quite the return!
The point I am trying to make here is not that investing is easy (far from it) but that one of the most useful tools for building wealth is right under our nose. Regular investing does not reduce risk, but it does allow you to build wealth consistently over time and at an average buying cost that can be below market value, given a long time horizon.
Some important points to raise here- this is not meant as a specific recommendation to buy or invest in anything- the purpose is to illustrate a point about the power of compounding. In the example above, I have ignored transaction fees and taxation.
The other vital point to remember here is that regular investing can remove all emotion, if done correctly.
Taking our example above, would you have committed capital during the depths of the COVID market selloff in March 2020? Or the height of the Eurozone debt crisis in 2011? Or the ‘taper tantrum’ selloff of late 2018? Regular investing removes this emotion and allows you to build a position slowly, taking advantage of low prices when they occur. We are more likely to stick with something when it is a habit, rather than a one-off event. Investing should be viewed the same- it is a continual process, not a one-off event.
I hope the above has been thought provoking and is of use to you in your investing endeavours.
All the best,
Louis
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