How monthly payments can smooth the market's bumpy ride

Long-suffering savers stuck with paltry interest rates and unable to keep pace with inflation are desperately seeking alternatives - and a monthly investment plan could offer a solution.

There has always been a clear divide between saving and investing, but in today's climate many are re-evaluating their views and questioning the price tag that saving in a traditional deposit account now carries.

The ace in the pack for savers has always been that their money was safe whatever happened. They might not make stellar returns, but there was no danger of losing any of their capital.

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This still remains true and despite the run on Northern Rock and the bail-outs of Royal Bank of Scotland and Lloyds Banking Group, savers can be confident that their money will remain intact whatever happens. Indeed the Financial Services Compensation Scheme guarantees that should a financial provider fail, deposits of up to 85,000 will be covered for each saver.

But while savers' capital may be safe, the combined impact of tax and inflation means that its value is falling. This means that keeping everything in a savings account could, for some, amount to "reckless caution".

Alan Steel, chairman of Alan Steel Asset Management in Linlithgow, said: "In each of the last 50 years, savers in regular deposit accounts have seen the value of their money fall. Ultimately they are sitting on a shrinking next egg and when they eventually stand up there will be nothing left. If people want their assets to grow then they have to focus on producing a return that outstrips tax and inflation. Historically this has been very hard to do in the savings market."

In other words, anyone looking for growth needs to consider putting some money in stock-market-based investments. This can, of course, be risky, but there are ways of mitigating that to some extent, including regular investing.

There has long been a perception among cash savers that the 25 or 50 payments they put aside each month would not be sufficient to give them access to the stock market. However, in the case of collective investments, this is not true and some of the biggest, oldest and most successful funds and investment trusts on the market will happily accept monthly instalments as low as 10.

The M&G Recovery fund, which has been running since 1969, is a case in point; with more than 6.5 billion under management it still accepts monthly payments from as little as 10.

Deciding to invest in equities does put the capital in question at risk. However, investing on a monthly basis helps to minimise that risk and smooth out the financial impact of volatile markets.

This is how it works.If you invest 50 into a fund costing 2 per unit, you will get 25 units.

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If the price of the fund falls, say to 1, you will be able to buy 50 units with the next month's purchase. In this example, the investor would have spent 100 to acquire a total of 75 units, which would carry a value of 75 after two months. By contrast, if a lump sum investor had invested 100 when the unit price was 2, the holding would comprise only 50 units and now be worth only 50. Therefore, if a fund falls in value, buying on a monthly basis helps to limit the losses - and provide investors with a greater number of units from which they can benefit when the fund recovers.

Chris Brown, director at Begley Brown Financial Solutions, believes that pound-cost averaging, as this effect is called, has a lot to offer investors.

He said: "The discipline of monthly investing is a good one to get into and the amount invested soon adds up. Investing in this way 'smoothes out' some of the market's peaks and troughs, which can help people protect their positions."

In the majority of cases, it should also be possible to avoid any up-front costs when investing monthly. There are, however, annual management charges (AMCs) that are applied to the total value of the fund and these can vary significantly. Investment trusts tend to be cheaper, with an average AMC of between 0.5 and 1 per cent, whereas the annual charge on unit trusts and open-ended investment companies is about 1.6 per cent.

To make life more complicated, the AMC is not exhaustive in the fees it covers, and the total expense ratio (TER) will give investors a better idea of what they will be charged each year. Unfortunately the TER does not tell the full story either, as it does not include the charges incurred by the fund manager when buying and selling stocks within the fund during the year.

Although investors should be careful not to pay more than they have to, Steel believes some of the funds carrying higher charges are worth it.

He explained: "If a fund performs over the long-term for its investors then paying a little bit extra for that performance far outweighs the charges. However, it clearly makes sense to move away from or avoid those funds that carry significant charges but are unable to justify them with sustained levels of excellent returns."

The investment market is not just for those with large capital lump sums and there is a large selection of funds that will accept small monthly investments.

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Regular savers despairing at the returns on offer will have to decide for themselves whether they are prepared to risk their capital and become regular investors. If interest rates stay on the floor in the months ahead, it will be an option that more savers have to consider.