Keep Calm and Seek Value…

… that’s the headline staring at me from this week’s copy of Investors Chronicle magazine.

Since starting the Amateur Investor a couple of weeks ago we have seen a big fall in share prices around the world and rioting in cities around the UK. Doom and gloom stared back at you wherever you looked. Whatever should we do…?

The unrest on the streets of England is a task too big for a humble Amateur Investor to begin to find a solution to or explanation for. But amidst the sea of red which masquerades as my portfolio I have tried to put the stock market woes into perspective.

Yes, we have seen big falls in share prices, portfolio values, ISA values and pension pot values but so what. Unless you are about to abandon the stock market and sell all of your shares, or give your portfolio pot to the nice Annuity man (or woman) does it really matter?

Stock market values are up and down every second of the trading day, every day of the trading week. So what if your portfolio is worth £10,000 one minute and £9,000 the next.

About a year ago the FTSE100 was just over 5100. Today it closed at 5320. OK, it’s only risen about 220 in 12 months, but it’s a rise isn’t it! And think of all the lovely dividends you’ve received throughout the 12 months.

OK, so the FTSE100 has peaked around the 6100 mark a few times in the last 12 months, but did you sell all your shares on one of these peaks? No, me neither.

That 6100 peak may have seen your portfolio showing a healthy profit. But it was a paper profit. And the low of around 4800 on Tuesday (9th) might have seen your portfolio showing a big loss. But again, only on paper. Did you sell all your shares when the FT100 hit this low? No, me neither.

If you are in it for the long haul, and let’s face it stock market investing should be seen as a medium to long term investment, the you are bound to see your fair share of share price peaks and troughs. And the current fall from grace represents about a 20% drop from the peak seen in May.

The Investors Chronicle article tells up that the gain in the S&P 500 from 2009 to 2011 was 102%. And the loss in the S&P 500 since May 2011 is 18%. Yes, 18% means nearly a 5th of the peak value of the S&P 500 has been lost. But don’t just think about the 18% loss, think about the preceding 102% rise to. There, an 18% loss doesn’t sound that bad, does it?

Many investors will have taken advantage of the recent market lows to pick up some “cheap” shares. I know I have. In fact, over the last few days I’ve bought some stocks more than once as the price continues to drop, taking the opportunity to pound cost average as it’s know. OK, OK, what i should have said is over the last few days I’ve bought shares I thought looked cheap, only for them to lose more ground so I’ve bought more to try to reduce the average price I’d paid for the shares.

Buying in a falling market can be a dangerous thing as do you really think you will be lucky enough to buy just at the point that the falling stops only to see the share prices rise and your “cheap” shares rocket in value? If you think you can call the bottom of the market then good luck to you (and do you mind just giving me a call and letting me know where the bottom of the market is likely to be please).

Market timing can be tempting, but nigh on impossible for us mere mortals.

Doesn’t the saying go that buying a falling share is like trying to catch a falling knife? i.e. dangerous.

So what should you do? Well that’s not for me to say. I’m not remotely qualified to give you financial advice. But what I would say is that if your portfolio is showing a loss then would it be the worst thing in the world to buy some more of the shares showing a loss, cheaper than you bought them before, and reduce the average buying price of the shares?

What I mean is best illustrated by a simple example of Pound Cost Averaging.

An example of Pound Cost Averaging

Say you bought 10000 shares of Company A at 100p per share.
Excluding dealing commission and stamp duty you will have spent £10,000 on 10000 shares, an average of 100p per share.

The market drops, drastically, and with it the share price of Company A. Their shares now stand at 50p. Your initial £10,000 investment is now worth £5,000 and the shares you paid 100p each for are now worth only 50p each – you’ve lost 50p per share.

So you now decide to invest another £10,000 in Company A. This time your £10,000 gets you 20,000 shares, twice as many as before.

You now have 30,000 shares in Company A which are worth 50p per share. That’s a current value of £15,000.

Your £20,000 has bought you 30,000 shares. That’s an average of 66.66p per share.

Company A now sees its shares rise back up to 100p per share. Your 30,000 shares are now worth £30000. You’ve spent £20,000 on shares which are now worth £30,000

If you had not purchased the extra shares when they dropped to 50p then you would be back to where you started. 10,000 shares worth 100p each. You have made the grand sum of no Pounds and no Pence. But instead you have 30,000 shares worth £30,000 and you only spent £20,000. That’s a £10,000 profit thank you very much (and luckily just below the Capital Gains Tax limit).

Are you still awake?

This is a very simplistic example. Pound cost averaging usually consists of a regular investment (perhaps once a month) of a fixed amount of money into a particular share. When the shares are cheaper your fixed investment buys you more shares, when the shares are more expensive you buy less. The result is that you smooth out the peaks and troughs of the share price which should mean the average price you have paid for each share is less that the arithmetical average of the market price. And you can’t ask for more than that.

Now, could someone please explain what I’ve just written…

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