Pound cost averaging
I have mentioned Pound cost averaging before, but this time I will use an example as the principle is important to fully understand.
The main idea behind Pound cost averaging is to provide some protection against the possibility of the stock market dropping just after your money is invested.
It reduces the chance of putting all your money in at the top of the market and then suffering capital losses if the market then pulls back. It doesn’t stop you suffering losses, but it reduces the size of the loss, as you haven’t committed your entire capital at the wrong time.
Most people invest on a Pound cost average basis anyway, as the most convenient way for them to invest is by monthly instalments.
However, if you ever were to come into a large sum of money and wanted to invest it all, you would then need to consider either investing it all at once or drip-feeding it into the market, to gain the protection of Pound cost averaging.
For example, Josh inherits £10,000 from a distant relative, and he wants to invest it. He may decide to put it all into the market immediately and hope the market rises.
Let’s say he buys a market index tracker currently at £10 per unit, so he buys 1,000 units.
A year later, the market index tracker is now at £9 per unit, meaning Josh has lost £1,000 to date.
Alternatively, Josh may have decided to buy £1,000 worth of the index tracker units each month, for ten months, to reduce his risk of buying the market near the top.
When the price goes up, fewer units are bought, and when the price comes down, more units are bought.
In our example, over the course of the year, a total of nearly 1,093 units were bought, with the price fluctuating both up and down. This compares to 1,000 units bought at the outset.
Josh has still suffered a paper loss after a year as the unit price is only £9.00, but as he has more units, his investment is worth £9,837, meaning a much smaller loss of just £163. His average buying price is £9.15, (1,093 units / £10,000).
It should also be noted, that if the markets did continue upwards after Josh bought his initial 1,000 units with a lump sum, and ended up a year later at £11.00, then the lump sum strategy would have produced a better return than Pound cost averaging, on that occasion.
Pound cost averaging does not guarantee a better return, it is a hedge against putting your money in at the wrong time.
View a pound cost averaging video explanation here on YouTube