How Pound-Cost Averaging Can Smooth Your Returns

This tried-and-true investment method helps investors navigate volatile markets and avoid emotional investment decisions

David Kathman, CFA 4 April, 2012 | 3:00PM
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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 Warren Buffett, avoid trying to catch the top or bottom of a market. It’s impossible to time markets perfectly, so it’s best not to attempt it.

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 opposed 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': a simple, time-tested method for controlling risk over time.

How It Works
The concept of pound-cost averaging is simple; the term simply refers to investing money in equal amounts at regular intervals. Most funds, whether they are OEICs or investment trusts/closed-end funds, are available through regular savings plans (such as ISA schemes), allowing an individual to invest on a monthly basis. In fact, if you have a defined contribution pension plan, you've probably already been pound-cost averaging by paying a set monthly amount direct from your pay cheque.

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About Author

David Kathman, CFA  David Kathman, CFA, is a senior fund analyst with Morningstar.

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