What is pound cost averaging?
Pound cost averaging is an investment strategy where you invest a fixed amount of money into an asset at regular intervals over a set period of time. This approach aims to benefit from the price fluctuations of the chosen asset to potentially maximise returns.
Pound cost averaging and negative pound cost averaging are both investment strategies that can help to reduce risk, but they also carry some inherent risks. In this insight, we'll delve into how these strategies work, the benefits and drawbacks, and when it may be advisable to seek professional advice.
Key Takeaways
- Pound cost averaging is a strategy used to try and avoid market fluctuations.
- The concept can be applied when drawing down on your pension, this is known as Negative Pound Cost Averaging.
- These strategies are complex and it's difficult to predict the future stock market moves.
- It's a good idea to seek pension advice if you are approaching retirement and planning to drawdown on your pension.
What is Pound Cost Averaging?
Assume an investor wants to purchase £1,000 worth of shares in a particular company. Instead of investing the full amount at once, they decide to spread out their purchases over 4 weeks, investing £250 each week.
Pound Cost Averaging Example
| Week | Price per share (£) | Amount invested (£) | Shares purchased | Total shares | Average cost per share (£) |
|---|---|---|---|---|---|
| Week 1 | 10 | 250 | 25.00 | 25.00 | 10.00 |
| Week 2 | 8 | 250 | 31.25 | 56.25 | 8.89 |
| Week 3 | 12 | 250 | 20.83 | 77.08 | 9.73 |
| Week 4 | 11 | 250 | 22.73 | 99.81 | 10.02 |
By using pound cost averaging, the investor bought more shares when the price was low and fewer shares when the price was high. Across the four weeks they paid an average of £10.02 per share, slightly less than the simple average price of £10.25. The effect looks modest here, but over months and years of volatile prices it can smooth out the cost of investing and take the emotion out of trying to pick the perfect moment.
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How does Pound cost averaging help?
Investors can use pound cost averaging as a strategy to reduce the risk of investing a large sum of money into an asset all at once. By investing a fixed amount of money at regular intervals, investors can spread out their asset purchases over time. This can help protect them from the risk of a sudden drop in the asset's price.
Pound cost averaging can also help investors take advantage of swings in the price of an asset. When the price of an asset is low, an investor can buy more of it with the fixed amount of money they are investing. This can potentially lead to higher returns when the asset price eventually rises.
While pound cost averaging can reduce investment risk, it's important to note that there are still risks associated with this strategy.
Negative pound cost averaging is another strategy investors may consider, but it also comes with its own risks. Seeking advice from a financial adviser can help investors determine whether pound cost averaging or negative pound cost averaging is the right strategy for their investment goals. If you are new to markets, our guide to investing for beginners in the UK is a good place to start.
Can you time the market?
Timing the market can be a profitable strategy, but it's also risky. It involves predicting market trends to buy and sell shares at the right time. While some investors have succeeded in the past, there is no guarantee of success and the risk of loss is high due to the unpredictable nature of the stock market. This strategy also requires extensive research and analysis, which can be time-consuming.
What are the advantages and disadvantages of Pound Cost Averaging?
Advantages of Pound Cost Averaging
Reduced Risk
Using pound cost averaging can help to reduce risk by spreading out the impact of short-term market fluctuations on the portfolio. By buying more shares when the price is low and fewer shares when the price is high, investors can achieve a more efficient portfolio diversification and potentially avoid major losses. This is the most obvious benefit of pound cost averaging.
Low Maintenance
Pound cost averaging is a simple and easy-to-implement investment strategy that requires minimal maintenance. Once an investor has established their investment plan, they can sit back and let the strategy work its magic. By investing small, regular amounts over a set period of time, an investor can potentially maximise their returns while minimising their risk exposure. This makes pound cost averaging an attractive option for those who are looking for a low-maintenance approach to investing.
Lower Transaction Costs
Pound cost averaging spreads out the costs of purchasing an asset over time, resulting in a lower average price per share purchase. This can be beneficial for investors as it allows them to buy more shares when prices are low and fewer when prices are high. By doing so, the investor is able to potentially maximise their returns and minimise the impact of short-term market fluctuations on their overall portfolio.
Disadvantages of Pound Cost Averaging
Missed Opportunities
Pound cost averaging is a strategy that can reduce the risk of sudden market fluctuations, but it may also limit potential gains.
By investing fixed amounts at regular intervals, an investor can benefit from the price volatility of an asset over time. However, this approach may lead to missing out on significant gains if the asset price rises quickly.
For example, let's say an investor starts investing £100 a month in a stock that is priced at £10 per share. Over the first few months, the share price fluctuates between £9 and £11, allowing the investor to buy more shares when the price is low. But if the share price suddenly jumps to £20, the investor may miss out on potential gains since they will only be buying a fixed amount each month.
Unfavourable Timing
Pound cost averaging can result in negative short-term returns since assets are purchased during unfavourable market conditions. This may prevent the portfolio from reaching its full potential.
Lack of Flexibility
Pound cost averaging requires the investor to stick with the same strategy for a long period of time, which does not allow for any flexibility. This lack of flexibility may result in missing out on potential gains or losses that may have been more profitable if the approach was more dynamic.
What is negative pound cost averaging?
Negative pound cost averaging is a strategy where you choose to drawdown your pension in fixed installments, over a set period, rather than take a lump sum. The strategy is designed to help you benefit from potential growth by leaving a larger amount in your pension. However, you could end up worse off if the market takes a downturn as it's harder to recover.
For example:
Take an illustration of two individuals, Mr A and Mr B, both aged 67 with £100,000 pensions, each withdrawing £7,500 in the first year and increasing that by 2% each year. Over five years they experience the same set of returns but in a different order. Mr A hits a bad year first, with returns of -10%, +4%, +4%, +4% and +4%, and ends up with a noticeably smaller pot. Mr B enjoys the good years first and takes the -10% hit only in the final year, leaving a larger pot.
Despite earning the same returns overall, Mr B finishes with meaningfully more than Mr A. This is known as sequence-of-returns risk, and it highlights why the order in which markets rise and fall matters so much once you start drawing an income. Because rising prices also erode spending power over time, it is worth understanding what inflation can do to a retirement pot too.
Is pound cost averaging a good strategy?
Overall, pound cost averaging is an effective way to reduce risk and stay disciplined when investing in the stock market. It can help investors protect their capital, maximise their returns, and focus on their long-term goals. However, the risks of negative performance are just as high. This strategy can be seen as a bit of a gamble. The stock market is difficult to predict. This sort of strategy is one best left the experts.
Seeking advice
It can be worth it to seek professional financial advice as you approach retirement age or consider investing. It's important to consider the potential benefits of having a tailored plan. Advice can help you to understand the options available to you, and give you a clear view of how to make the most of your money. For more ideas, see our guide to making the most of your pension.
This insight is general information and not personal financial advice. The value of investments can fall as well as rise and you may get back less than you put in.
