Pound Cost Averaging

I have mentioned Pound cost averaging before, but what exactly is pound cost averaging and why is it important to investors?

The best way to fully understand and appreciate the principle of pound cost averaging is by way of an example.

At some stage in your life, you may receive a relatively large sum of money. It might be from an inheritance, or a lifetime gift, a maturing savings plan, the sale of a house or even the sale of a business or other valuable asset, it could even be from the Premium Bonds or a Lotto win if you are very lucky indeed.

No matter how you get this money, you must then make the decision about what you are going to do with it, and if you plan to invest it, your decisions will be:

Do I invest it all at once? or,

Do I drip feed it into my portfolio by instalments over a period of time?

Investors faced with such a decision often decide on the latter method, and spread their investment out. This means that instead of buying assets at a single price, they buy assets at many different prices over the coming months, and thus the overall purchase price is averaged out.

This 2nd investment strategy is what is often called “pound-cost averaging”.

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 averaging basis anyway, as the most convenient way for them to invest is by monthly instalments.

But as noted above, 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.

Pound cost averaging example

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 (see table below), 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), and not £10 as would be the case if he had bought a lump sum.

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.

What are the benefits of pound-cost averaging?

Pound-cost averaging is more often than not used as a form of hedge or some protection against the stock market or other assets from falling in value shortly after the main principle has been invested.

It prevents the investor from buying everything at the top of the market, and then regretting that decision when markets subsequently fall. Instead, the shares are bought regularly, usually on a monthly basis and as the stock market price increases and decreases over that period, an average purchase price will be established as opposed to a price at the peak of the market.

in short, pound cost averaging can help smooth returns in investment markets that constantly move up and down.

What are disadvantages of pound-cost averaging?

Pound cost averaging is not a free lunch as it were in investing, there are disadvantages, such as potentially delaying investment returns that would have been earned if the market continued to rise.

In a strong bull market, rising market, the decision to pound cost average over a 12 month period could prove very costly in hindsight, as the investment returns will be far lower on an average basis than had the full investment some been committed on day one, and then enjoyed a full years rising market, but this is the price of the hedge or caution of pound cost averaging.

You should also be aware, that when you have made the decision to drip feed your investments into the market and benefit from pound cost averaging, you will probably have a considerable cash lump sum sitting in a very very low interest rate or alternatively zero interest rate account, therefore not making the best use of these funds as they sit and wait for their time to be invested.

In Summary

Most people use regular monthly investments into their stocks and shares ISA or pensions anyway, and so they are pound-cost averaging by default, which brings both the advantage's and disadvantages described above.