Gently does it: Volatility serves as a reminder of the power of pound cost averaging

Pound cost averaging can instil good discipline and remove some of the emotional stresses linked to investing money.

Volatility serves as a reminder of the power of pound cost averaging

Deciding when to invest can befuddle even the most seasoned of investors. The detached, rational investor understands that worrying too much about the entry point is foolish. However, in the real world we are human – more like Homer Simpson than Star Trek’s Spock than most of us would care to admit.

Investors have been paralysed by the ‘should I, shouldn’t I invest’ dilemma

Whether it’s your own money, or that of a client, taking the decision to invest in one go is bold and nerve-jangling. Especially during turbulent market conditions. Unfortunately, time and time again, investors have been paralysed by the ‘should I, shouldn’t I invest’ dilemma. This can lead to deferring investment, or in the worst-case scenario, never investing at all. Either way, it will be detrimental to longer-term financial goals.

So how can we help protect against such emotional turmoil?

Pound cost averaging

A tried and tested solution is pound cost averaging. By drip feeding investments over the course of a few weeks, months or even years, peaks and troughs of the share price can be averaged out; avoiding the gut-wrenching feeling any immediate and/or significant loss would induce. It also stops investors trying to second guess the markets.

Figure 1: A simple example of pound cost averaging
Source: Aviva Investors as at 30 April 2020
Source: Aviva Investors as at 30 April 2020

The temptation of investing in one go can be hard to resist. Get lucky, and the rewards can be large. However, the opposite is also true and, if the market takes sharp downturn shortly after the investment is made, it could lead to some difficult conversations. Nobody likes losing money.

The potential benefit of pound cost averaging in volatile markets

However, compared to lump sum investment, pound cost averaging really comes into its own in downward markets. An example from the 2008 Global Financial Crisis makes the point.

  • Option A: £120,000 invested in 12 instalments of £10,000 each month.
  • Option B: £120,000 invested in one lump sum at the beginning of 2008.
Figure 2: Pound cost averaging delivered a better outcome during the volatile period
Source: Lipper as at 30 April 2020
Source: Lipper as at 30 April 2020

Clearly, option A had the much better outcome. Essentially, investing regularly in volatile and falling markets results in buying more shares at a cheaper price than the lump sum investor. And by the end of 2010, when markets had recovered, the investment value of option A was approximately £22,000 higher than option B and in positive territory. Option B’s investment value, on the other hand, was still below the initial investment amount.

In addition to better performance, drip feeding the investment (in this example) also reduced the investors maximum loss by £13,000 – i.e. option A’s lowest value was £75,000 compared to £62,000 for option B.

Minimising losses in downward markets

Figure 3: Pound cost averaging minimised investment losses during the period
Source: Lipper as at 30 April 2020
Source: Lipper as at 30 April 2020
It's almost always better to simply start investing, than to never invest at all

Like any strategy, pound cost averaging will not always deliver the best investment return for a client. However, particularly when markets are volatile and they are nervous about investing, it can be useful strategy to overcome the emotional hurdle of investing, as well as helping to minimise losses in a downward market. Ultimately, to achieve our financial goals we all need to be invested. It is therefore almost always better to simply start investing, than to never invest at all.

Key risks

Investment risk

The value of an investment and any income from it can go down as well as up and can fluctuate in response to changes in currency exchange rates. Investors may not get back the original amount invested.

Derivatives risk

The fund uses derivatives; these can be complex and highly volatile. Derivatives may not perform as expected, which means the fund may suffer significant losses.

Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL) as at May 28, 2020. Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This material is not a recommendation to sell or purchase any investment.

In the UK & Europe this material has been prepared and issued by AIGSL, registered in England No.1151805. Registered Office: St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority. In France, Aviva Investors France is a portfolio management company approved by the French Authority “Autorité des Marchés Financiers”, under n° GP 97-114, a limited liability company with Board of Directors and Supervisory Board, having a share capital of 17 793 700 euros, whose registered office is located at 14 rue Roquépine, 75008 Paris and registered in the Paris Company Register under n° 335 133 229. In Switzerland, this document is issued by Aviva Investors Schweiz GmbH.

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The name “Aviva Investors” as used in this material refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom. Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is registered with the Ontario Securities Commission (“OSC”) as a Portfolio Manager, an Exempt Market Dealer, and a Commodity Trading Manager. Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) registered with the Commodity Futures Trading Commission (“CFTC”) and is a member of the National Futures Association (“NFA”).  AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606.

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