Pound Cost Averaging: how you can smooth your investment returns

Investors often fear that they are putting money in at the top of the market. Here we illustrate how long-term investors need to factor in the value of re-invested dividends, and why they can embrace volatility due to the beneficial effects of Pound Cost Averaging.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
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The media and many investors have a habit of keenly monitoring the levels of stock indices, and when the Dow Jones Industrial Average reached 20,000 points in January 2017 it was greeted with euphoric headlines. The FTSE 100 has had a rather less illustrious time; having been bid up during the dotcom boom to a heady 6,930 points on 31 December 1999, London’s blue-chip index did not reach that level again for another 16 years.

Rollercoaster markets over recent history have scarred a generation of UK investors. On the other hand those invested in property have seen their assets grow considerably since the dotcom crash, with the UK IPD Total Return All Property Index up 275%, or 8% on an annualised basis. It has benefitted considerably from a lower starting point valuation and a falling interest rate environment. 

But looking at the headline index level misses one crucial component: dividends. Let’s look at how an investor who put all their assets into the FTSE 100 at the top of the market back in 1999, when the market traded at twice today’s level on a price-to-book valuation, would have fared. On a headline level the FTSE 100 had gained just 4.5%, but when dividends are re-invested, the investor could have made 78%.

In short, re-investing dividends added 3.5% to returns on an annual basis. The chart below shows how an investor who allocated a lump sum of capital to UK equity markets might have performed, assuming no fees or transaction costs.

Of course, most UK investors do not just own the FTSE 100, and the FTSE All Share (which includes the FTSE 250 and small cap exposure) performed rather better (+121%), as did global (+131%) and emerging market (+277%) equities, illustrating the benefits of adding diversification to your investment portfolio. 

Pound Cost Averaging

Most investors don’t have the luxury of a lump sum of money to invest in the market in one go, instead relying on regular contributions into a pension or perhaps an ISA with monthly savings from their salary.

But those regular investors can benefit from what is known as ‘Pound Cost Averaging’, in which short-term falls in the market are actually to be welcomed as they enable you to buy more shares at a lower cost. For example if you invested £100 pounds into an index Exchange Traded Fund which cost £2, you would acquire 50 shares in month one. If the price of the index ETF subsequently fell to £1.75, you would be able to buy 57 shares with the same amount of money. Should the price of the index ETF eventually rally to £3, the initial investment at £2 would record a 50% gain, and the shares bought at £1.75 would have a 71% gain.

In the example below we can see what impact Pound Cost Averaging would have on someone saving £100 a month into the FTSE 100 since the December 1999 peak. We know from the graph above that the market bottomed in March 2003, but for a regular saver just starting out it enabled them to continually pick up cheaper stock.  

To the end of April 2017, for a total investment of £20,800, the FTSE 100 investor - even when starting at one of the worst points in living memory - would have accumulated £38,800, a gain of £18,000 and an internal rate of return (IRR) of 6.6% per annum. Pound cost averaging both smoothed returns, and also resulted in a better return than a lump sum investor would have achieved.

That said, monthly saving will not necessarily result in better returns than someone investing a lump sum, as there’s no guarantee that markets will fall. Certainly from a long-term viewpoint, stock markets should always rise over time as they represent the best way for an investor to participate in the growth of the global economy.

From a behavioural aspect, monthly saving is still a very important habit to get into. For people making a lump sum investment, their perspective will usually be framed by how much they have made or lost relative to that initial investment. Behavioural biases such as cutting the winners and loss aversion (holding onto the losing positions for too long) start to dominate thinking. On the other hand, the monthly saver is less likely to react to market peaks and troughs, due to the systematic nature of their investing behaviour. In the long run, adding when markets are cheap (rather than panic selling) if you can afford it, should prove a winning strategy.

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