Building an investment portfolio: understanding pound cost averaging
Volatility and falling prices are the biggest fears for any investor. However, by investing smaller amounts over time rather than in larger single lump sums, you could buy investment units for cheaper on average, taking advantage of typical price volatility. But does pound cost averaging always work?
What is pound cost averaging?
Pound cost averaging involves investing smaller amounts of capital over a period of time rather than a large sum in one go. As prices rise and fall as time goes by, spreading your investments out means you are likely to achieve a lower average cost of buying each investment unit. You are averaging out the peaks and troughs of price movements over time.
Why is this important? It’s all about market timing
The problem with the lump sum approach is that you are essentially trying to time the market: you’re hoping that you’ve got in at a low point from which markets will rise, increasing your capital. But even the world’s most famous fund managers admit they don’t have a crystal ball and can’t correctly time market peaks and troughs, so it’s unlikely an amateur investor can either. If you get it wrong, and markets take a nosedive just after you’ve invested your entire pot of capital, you feel the loss across your whole investment.
A strategy of investing smaller amounts regularly gives you a better chance of getting into the market at the right time, and gives you the opportunity to benefit from pound cost averaging.
Read more about whether it’s time in the market or timing the market
Smoothing your investment returns
The crux of pound cost averaging is that when markets fall, you are able to pick up more shares or fund units for your money because the price has dropped. Pound cost averaging is especially beneficial during times of volatility and falling markets. It gives you some protection as you only suffer losses on a small portion of your capital at once. It smooths out your returns because, even if the price of an asset fluctuates a lot over time, you are drip—feeding money in so you’ll be buying at different prices. This means your portfolio should perform better when markets recover.
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However, it also works the other way. When markets rise and share prices go up, you get fewer shares for your money. So if you take the ‘little and often’ approach to rising markets, chances are you will end up paying more per share on average than if you had invested a larger sum before markets began to rise. But again, no one knows exactly when markets will rise, so the chances of you getting in at the perfect time would be slim.
Is pound cost averaging a strategy for falling markets?
You can find plenty of figures ‘proving’ that regular investing is better than lump sum investing, and some which show the opposite, depending on where you look. For example, Vanguard’s research shows that lump sum investing is the right strategy because markets go up more often than they go down. It notes that, over the last 20 years, the stock market (represented by the FTSE All Share) has risen in 60% of individual months, and fallen in 40%. That means investors using pound cost averaging would be buying shares at increasing prices, an inefficient strategy.
Robo—adviser Moneyfarm has also done some analysis, comparing a £13,000 lump sum investment with a monthly contribution of £1000 a month into a UK stock exchange traded fund (ETF). It found that drip—feeding works better. A lump sum investment strategy would have cost an investor £6.60 per share on average, and they would end up owning a total of 1969 shares. By contrast, with regular investing they would have paid an average of £6.25 per share and would own 2081 shares by the end of the period. This equates to a 5.4% discount in price terms.
|Monthly contribution approach|
|Lump sum investment on 01/06/2018||£6.60||£13,000||1969|
Pound cost averaging has the potential to dampen both losses and gains, but perhaps of greater importance is that it helps build a regular investing habit which can build long—term financial security. And you can’t put a price on that.