Stock market investing for the long term

UK

Prudential’s asset manager, M&G, examines the movement of stock markets over 20 years and the role that long-term investing plays in different asset classes.

Letting time do its work

Trying to predict market activity over short time periods, often referred to as ‘market timing’, can be a risky strategy and investors can often miss some of the best days when gains can be made.

Invest for the long term

We believe that, ideally, investors should plan to invest for at least ten years. Over the long term, share prices tend to reflect the underlying reality of companies and the returns they deliver to shareholders.

But over shorter periods, equity markets are rarely smooth and can experience extreme turbulence brought on by catastrophic events or just plain old erratic investor behaviour. Equity markets can overreact to new developments with unpredictable, and sharp, falls and gains in share prices. Second-guessing those short-term moves is, we believe, a dangerous and potentially expensive game.

Market behaviour

We looked at how stock markets have moved over the past 20 years, both in the UK, as measured by the FTSE All-Share Index, and globally, by the FTSE World Index.

To gauge how markets have behaved over short and longer-term periods, we took returns from the start of each month over every single-year period (229 in all), every five-year period (181) and every ten-year period (121). In the charts below, we show the average returns per annum over each of these periods for the UK and global markets. We also show the likelihood, on average, of investors having made money or lost money in each. The data would suggest that, the longer investments are held, the lower the risk of losing money.

UK equities and Global equities

Past performance is not a guide to future performance. The value of stock market investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested.

Time, not timing is key

Investing a single sum in the equity markets can be highly beneficial if the investor gets the timing just right. But that is very difficult to do in practice. When market conditions become uncertain, investors will be wondering what the best course of action is. It may be tempting to sell existing holdings or delay making new investments and wait until markets feel less volatile and values are low.

An investor who stayed in the market throughout the past 20 years would have earned good returns, well above inflation. If, however, that investor had attempted to time the markets, he or she may have missed the ‘best days’, and because markets can move sharply over the short term, those days can be very important.

Invest regularly

Investing at regular intervals can be a good idea to help smooth out the ups and downs of the market. As we said, timing the exact moment to enter or leave the market can be dangerous – you run the risk of investing at the top of a market cycle, or exiting at the bottom.

Buying continuously means that the average price you pay can be lower than if you’d made one lump sum investment. Of course, when the market falls, your existing investment will be worth less. So, over time, regular investments can help smooth out the peaks and troughs.

Pound-cost averaging

Regular investing also has another benefit, known as ‘pound-cost averaging’. This is demonstrated in the following tables, showing the number of shares purchased by a monthly investment of £100 as the relevant share price both rises and falls. As the share price rises, the investor buys fewer shares for each £100 investment and, conversely, more shares as the price falls. This means that, on average, the purchase price paid is lower than the share price over the period.

Rising market

  Investment Share price Number of shares bought
Month 1 £100 £1.00 100
Month 2 £100 £2.00 50
Month 3 £100 £3.00 33.3
Totals £300 £6.00 183.3

Average share price: £6.00 / 3 = £2.00
Average price of shares bought: £300 / 183.3 = £1.64
Source: M&G, for illustrative purposes only

Falling market

  Investment Share price Number of shares bought
Month 1 £100 £1.00 100
Month 2 £100 £0.67 149.3
Month 3 £100 £0.33 303.0
Totals £300 £2.00 522.3

Average share price: £2.00 / 3 = £0.67
Average price of shares bought: £300 / 552.3 = £0.54
Source: M&G, for illustrative purposes only

Past performance is not a guide to future performance. The value of stock market investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested.

Historically the best asset class over the long term

Equity (and bond) investments have historically outperformed cash over the long term. The average annual return on UK investments between 1989 and 2014, adjusted for inflation, is 5.2% for equities, 4.6% for bonds and -0.8% for cash. (Morningstar, Inc., and M&G, as at 30.11.14). However, although cash offers very little potential for growth or income, it is less risky than equities or bonds. While there is no limit to how much an equity investment can grow, there is also no limit to how much it can fall. This is another reason why equities are best held for the long term.

Hold for the long term

We believe the pattern of equity returns has been compelling – the longer an equity investment has been held, the less likely it has been to lose money, and the more likely to make money. The longer shares are held, the greater the probability they will make a positive return. In other words, letting time do its work has usually been the best approach to equity investment.

Important information

The views expressed in this document should not be taken as a recommendation, advice or forecast. We are unable to give financial advice. If you are unsure about the suitability of your investment, speak to your financial adviser. Past performance is not a guide to future performance. The value of stock market investments will fluctuate, which will cause fund prices to fall as well as rise and you may not get back the original amount you invested.