2 very different ways to invest during the market crash
Investment manager Ted Richards takes us through the differences between lump sum investing and dollar cost averaging when the stock market is down.
Share market valuations have plummeted in the past few weeks, providing some rare opportunities for investors looking for bargains. If you're fortunate enough to be sitting on some cash, you might be wondering if the share market offers any opportunities for you right now.
But how do you invest in the share market when prices are changing so much from day to day? If you purchase a pair of shoes at a discounted price it's easy to see the opportunity and feel confident you're buying a bargain. But buying shares when prices drop seems to make us feel even more nervous.
If you're thinking about investing but you're worried about when to do so, learning more about how it works is a valuable starting point. So here's a look at two different approaches to entering the market right now: the lump sum investment and dollar cost averaging.
Lump sum investments
A lump sum investment is exactly as it sounds: you put a lump sum of money into an investment on a chosen day. For example, you might decide to invest $10,000 today. This could be spread across a few individual companies or a portfolio of exchange-traded funds (ETFs).
Dollar cost averaging
Dollar cost averaging is slightly different. You make planned, smaller contributions to your portfolio over a period of time. So instead of investing the full $10,000 as in the example above, you might invest $2,500 today and then $2,500 every month for the next few months. Once again, this can be done with individual companies or a portfolio of ETFs.
When you use the dollar cost average approach, if the market goes down over the short term, you aren't fully exposed to the downside and will be adding to your portfolio at a discounted valuation. On the other hand, if the market goes up over the short term, you are still capturing some of the upside with the investments you have made.
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So which is the better investment strategy?
We will only know which of these is the better strategy for a particular person or scenario with the benefit of hindsight – and it's often hard to differentiate luck from skill when it comes to timing investments.
But something to consider with dollar cost averaging is that it is all about hedging your investments to ensure it's not the worst strategy. And when it comes to investing, never being "the worst" carries less risk than trying to be the best.
Another point to think about: most professionals struggle to time the market with any real accuracy and consistency. Recently billionaire Gerry Harvey made a lump sum investment which initially didn't pan out so well. To be fair, it's only been a short period of time and I'm sure his investment horizon wasn't just a few weeks (sorry for bringing this up, Gerry!).
If professionals struggle to pick the bottom of the corrections it's hard to argue that a beginner will fare any better (especially if you're doing this for the first time).
Whichever approach you take, investing in this market isn't easy. Stocks are down for a reason, and recent headlines point to a lot of negative developments in the future. Some of this negative news will occur but, importantly, some will never eventuate.
Recession is a word that the media is focusing on right now. I will note that there isn't a perfect cause and effect relationship between recessions and stock market crashes. A recession is a general slowdown in economic activity of at least two economic quarters, and from a historical point of view they are often relatively short-lived (less than one year). Furthermore, stocks can perform very well in the years following a recession.
So if you're trying to predict not just when a recession will occur, but how long it will last or when the bottom of this stock market down cycle will be, do note that it's almost impossible to get these calls right. It's for this reason that I have a preference for the dollar cost averaging approach to investing right now. There will probably be further bumps in the road ahead, but we do know from history that markets trend up over time and, at some point in the future, we could look back at these times with a very different mindset to the nervousness some are feeling right now.
Ted Richards is Director of Business Development at online investment service Six Park and host of investment podcast The Richards Report.
Disclaimer: The views and opinions expressed in this article (which may be subject to change without notice) are solely those of the author and do not necessarily reflect those of Finder and its employees. The information contained in this article is not intended to be and does not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort. Neither the author nor Finder have taken into account your personal circumstances. You should seek professional advice before making any further decisions based on this information.
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Images: Getty Images, Supplied
