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The Benefits of Pound Cost Averaging

Market timing can be tempting, but making regular investments is a far better plan.

Morningstar Equity Analysts 8 November, 2007 | 5:24PM
Morningstar was founded in 1984 to help investors make better decisions. We provide a wealth of free fund data and analysis at Morningstar.co.uk to help you do just that, and we are now introducing our Fund ABCs series to help educate investors about fund investing. We will be posting new articles periodically, progressing from the most basic concepts through more complex topics such as fund evaluation and portfolio building. This is the fourth article in the series, “The Benefits of Pound Cost Averaging? As always, we welcome your feedback.

In this course

1 Monthly Savings
2 Benefiting from a Falling Market
3 Smoother Returns

One of the biggest dilemmas investors face is market timing. Jumping in and out of markets on a regular basis not only requires constant monitoring of daily events but also requires the skill to act on such events. Even the best fund managers, such as Anthony Bolton or Warren Buffett avoid trying to catch the top or bottom of a market. In fact Warren Buffett recently sold a large stake in PetroChina, the Chinese state owned oil company, and admitted that he might have sold too early. The message here is that it’s impossible to time markets perfectly, so it’s best not to attempt.

But that leaves us with a quandary: we want to invest and achieve the best returns for our future but we don’t want to put our hard earned capital at risk just at the wrong time. What we want to do is improve our chances of entering the market at the right time. One way to achieve this is to spread or drip-feed one’s lump sum into the market as oppose to investing it all in one go. In fact during volatile times this strategy allows one to benefit from what is known as ‘pound cost averaging'. So how does it work?

Monthly Savings
The concept involves investing on a regular basis and most funds whether they are OEICs or investment trusts are available through regular savings plans (such as ISA schemes) allowing an individual to invest on a monthly basis. The beauty of this arrangement is that not only does it instill a sense of discipline to one’s investment habits but also avoids trying to second guess market movements and averages the cost of buying an investment. Of course this means that a regular investment of say £100 a month, buys less fund units when markets rise but a higher number will be purchased when shares fall. For example, until recently, the last twelve months has been a good time for markets. And if one had invested a lump sum of £1,200 into the Legal & General UK Index Acc fund (which tracks the FTSE All Share) in December 2006 the value of the fund would have been worth £1,344 a year later. Whereas investing a £100 a month for twelve months results in a lower return of £1,268.

Benefiting from a Falling Market
However, it’s in falling markets that Pound Cost Averaging really comes into its own. This is illustrated if we compare how investing £100 a month would have prospered compared to investing the full £1200 in one go during 2002, the last year of market falls. Once again Legal & General UK Index is the example fund.

Legal & General UK Index: The Benefits of Pound Cost Averaging
Month Price
of Units
No. of Units
Purchased
(Monthly)
No. of Units
Purchased
(Lump Sum)
January 1.11 90.1 1081
February 1.11 90.1 0
March 1.10 90.1 0
April 1.14 87.7 0
May 1.12 89.3 0
June 1.10 90.1 0
July 1.02 98.04 0
August 0.91 109.9 0
September 0.92 108.7 0
October 0.82 122.0 0
November 0.86 116.3 0
December 0.91 109.9 0
Total Units 1202.24 1081
End Value 1094.04 983.71

So as we can see investing regularly in volatile and falling markets results in buying more shares and at a cheaper price: the average purchase cost for the monthly investor would have been 100p, where as for the lump sum investor it would have been 111p.

Smoother Returns
Pound Cost Averaging also makes for a smoother ride as the following chart depicts:


The strategy of drip feeding makes market volatility work for the investor during falling markets, which will ultimately boost performance when markets recover.

Given current market woes - a falling dollar, rising oil prices and mounting credit losses - investors can be forgiven for feeling a little uncertain about markets. Pound cost averaging would seem to be a logical strategy for such investors at this juncture.

Summary
  • Pound Cost Averaging is a technique that reduces exposure to falling markets from investing a lump sum. By investing at regular intervals more shares are purchased when share prices are low and fewer shares are purchased when prices are high.
  • The investor will be better off in falling markets.
  • The investor will be worse off in rising markets.
  • Instills a sense of investment discipline which avoids second guessing markets.
  • Most Fund Management Companies/Fund Supermarkets offer regular savings plans.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Morningstar Equity Analysts  Morningstar stock and fund analysts cover 2,000 mutual funds, 2,100 equities, and 300 exchange-traded funds.