If you’re unclear on what the term ‘pound cost averaging’ means, the simplicity of what it describes is perhaps best demonstrated through an example. Abbie is an investor who has already decided where she wants to make a long-term investment. She also earns money through her job and invests more each month. Abbie therefore has three options as to how to invest her money. Firstly, she could invest all the money she currently has immediately, then invest the rest as she earns it. Alternatively, Abbie could hold on to her investment money and add to it as she earns more, waiting for the optimum time to invest a larger sum all in one go. Abbie’s third option is to stagger her investment, pacing herself so that the money is invested gradually over time.
This third approach is ‘pound cost averaging’ – staggered investment of relatively small sums of money in a regular schedule. It’s a method of investment which has a number of benefits. First of all, it reduces your exposure to falling markets which you might experience when investing a lump sum all in one go. Investing according to an established routine means you’ll be purchasing a larger number of shares when prices are low and fewer shares when prices are high.
A second advantage of pound cost averaging is the cushion it provides for you if the market falls. Let’s consider a scenario where Abbie had £10,000 and invested it all in one go into a diversified portfolio. If the market consistently fell over the course of twelve months so that Abbie’s portfolio was worth only £9,000 a year after her initial investment, she would have lost 10% and would need to grow that investment by more than 11% to regain her portfolio’s original value.
Using a pound cost averaging strategy investing £1,000 each month over a sustainable savings routine, Abbie is able to buy more assets at a lower price each month as the market falls. The assets purchased later also spend less time in the falling market. As such, Abbie’s portfolio has a greater value after twelve months than it would have had under the scenario where she invested a lump sum all at once.
Another benefit of pound cost averaging is the good behaviour it instills in investors. By having an established routine, investors overcome the temptation to attempt to time the markets, a method which often leads to worse returns than sticking with a long-term investment. Pound cost averaging can be achieved through automation such as a direct debit from your bank account. As such, investment feel less like a gamble dictated by short-term gains and losses, and more like the ongoing and disciplined activity it needs to be for long-term success.