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