Pound cost averaging sounds complicated, but the unwieldy term describes a very simple process.
Imagine you have money to invest. You already know where you’re going to invest it and you also know you’re going to make a long-term investment. As time passes and as you earn money by working, you’ll be investing more each month.
Now, you need to decide when you commit your money to the market. Do you invest it all immediately, and invest the rest as you earn it? Or do you save it up, and invest a larger sum all in one go when the market conditions are right? Or do you stagger it, pacing yourself so the money is invested gradually over time?
The third approach describes what’s known as ‘pound cost averaging’. Put simply, it means investing relatively small amounts in a very regular, staggered way. Here’s why you might want to consider it.
Instilling good behaviours
Firstly, pound cost averaging instills good investing behaviour – by establishing a routine.
Most investors know that attempting to time the market, investing when the market dips and selling when it peaks, is almost impossible. Often, trying to do this leads to worse returns than simply holding an investment over the long term. Regardless of this, the temptation to panic and cut our losses can be strong, and even the most experienced investors could succumb to it.
Having a routine could help to overcome this temptation. Routines are especially helpful if the investment process is automated – for instance, by direct debit transaction. When you invest as a matter of routine each month, regardless of market conditions, investing doesn’t feel like such a gamble.
A routine also helps us view investing as a truly long-term, continuous activity. When you’ve invested a single sum, it’s very tempting to withdraw it from the market when it’s made a significant gain – say, if you’ve turned £10,000 into £15,000. Equally, when you’ve invested a single sum and your portfolio is down, the temptation to withdraw is far stronger.
Establishing a routine helps us think of investing as an ongoing activity that continues regardless of temporary gains or losses.
Cushioning market falls
Spreading your payments over time makes you a more disciplined investor. It also has a second advantage: it cushions your losses if the market falls.
Imagine you were to invest £10,000 into a diversified portfolio – perhaps one built by an investment manager like Nutmeg, perhaps one you’ve designed yourself. Imagine the market falls consistently over 12 months, so you’re left with a total portfolio of just £9,000. You’ve lost 10% of your investment, and you’ll have to grow your £9,000 by over 11% to recover the portfolio’s initial value.
Compare that with a pound cost averaging strategy.
Under this strategy, you invest £1,000 each month, staggering the investment and setting up a more sustainable savings routine for the future. As the market falls in value, it becomes possible to buy more assets at the lower price, and assets invested later spend less time in the falling market. As a consequence, the final value of this portfolio is £9,356 – you’ll end up £356 better off than if you’d invested the single lump sum.
The effect of pound cost averaging is, as the name suggests, that the cost at which you buy the stocks will average out over time. Some months your stocks will be more expensive if the markets are doing well, and some months they will be better value, as the market is down.
Of course, there’s a flip side to this. In a rising market, money not invested early misses out on market gains, so your portfolio gains will be dampened just as losses are in a falling market.
What kind of investor uses pound cost averaging?
In general, pound cost averaging is used by investors who want to cement good behaviours – regular investing, and avoiding the temptation to time the market. These behaviours should be priorities for everybody.
The technique is also used most often by those who are investing from salary, instead of from a lump sum like an inheritance – although of course it can be used on a lump sum, as the example above demonstrates.
At the same time, pound cost averaging does dampen both losses and gains. As a consequence, investors with a higher-risk appetite might prefer to front-weight their payments, putting money into the market quickly, tolerating heavier losses should they occur but capturing significant gains if the market rises.
In summary, whether you employ pound cost averaging or not is a very personal choice, which should be influenced by your risk appetite, how much importance you place on embedding good investing behaviours, and your financial circumstances.
Risk warning: As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past or future performance indicators are not a reliable indicator of future performance.