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Sometimes fears over a possible stock market crash – like the one we saw in the first quarter of 2020 – is enough to stop people investing altogether. After all, nobody wants to put in £100,000 all at once, only to see it sharply fall 20% in value. Yet there’s a great way to surmount that fear called “dollar cost averaging”; or, pound cost averaging, for the purpose of our readers.
Here, our financial advisers at Cedar House offer an outline of how pound cost averaging works, especially during a volatile market (e.g. one induced by a pandemic). We hope you find this content helpful. Please contact our team here at Cedar House for more information or to access personalised advice:
020 8366 4400 or firstname.lastname@example.org
What is pound cost averaging?
In short, the basic idea behind pound cost averaging is to “drip-feed” money into stock market investments, month by month, rather than by committing a large lump sum. Instead of putting £12,000 straight into equity investments, for instance, you could commit £1,000 per month over the course of a year. This can be especially appealing to investors during a turbulent market or falling market, since you do not stand to “lose” all of your investment should things take a turn for the worse. You still have your remaining capital in reserve – perhaps held in cash, which will not fluctuate in value in line with stock prices.
When is pound cost averaging better than a lump sum?
To answer this, imagine two scenarios. In the first, a market index (e.g the FTSE 100) is steadily rising over the course of 12 months. In the beginning, for instance, the index might be valued at 1,000 points, yet by the end, it stands at 1,500. This is an ideal scenario for committing a lump sum investment, since the total amount will have risen in value by month 12. Here, pound cost averaging is arguably less effective, since by “drip feeding” you’d be continually picking up the higher prices each month rather than capitalising on the lowest price in month 1.
In scenario 2, let’s imagine a falling stock market – like the one earlier in 2020. In month 1, the price of our market index is highest, and the price falls each month to its lowest point in month 12 – when you (the investor) suddenly decides to sell. Here, a lump sum investment in month 1 would have been “worse” than pound cost averaging, since you bought at the highest price and sold at the lowest. The investor who, instead, “drip-fed” his/her investment over that time would keep buying stocks as they decrease in value. If this investor then stays in the market once it goes back up again, then in the long term they increase their overall return compared to the “lump sum investor”.
Pound cost averaging during a pandemic
Given the above scenarios, why would an investor choose pound cost averaging – especially when, over the long term, markets tend to rise (despite short-term dips in performance)? After all, the beginning of 2020 marked a 11-year bull run since the 2008-9 financial crisis, and so lump-sum investors who committed their cash at the start of this timeframe will have been better off compared to “drip-feed” investors.
The answer, of course, lies in the uncertainty of the markets. If financial advisers, investment managers and retail investors were able to fully-predict when a bull run will start and end, then a lump sum investment would, of course, be best. You would buy at the lowest point and minimise transaction costs along the way (which you would incur from multiple, smaller investments). Yet nobody knows what will happen in the markets, and when. It’s impossible to tell whether or not the market will suddenly fall after you commit a huge lump sum, even when the outlook appears to be near-perfect (as it did in January 2020).
As such, one of the main benefits of pound cost averaging is that it can help investors overcome their cognitive bias. In other words, during good market conditions, it’s better to invest in a sub-optimal way than to not invest at all. If things then take an unexpected turn for the worse, you can buy some “bargain stocks” each month which have fallen in value – with the intention to reap greater returns in the long term.
Conclusion and Invitation
There are situations where committing a lump sum to the stock markets is a wise option. At the time of writing in July 2020, when stock markets are still tentatively rallying as lockdowns ease across the world, many investors are reluctant to start investing because they think that a lump sum is their only option – which might seem too risky under current circumstances.
With pound cost averaging, however, there is another way to engage in the equity markets which allows you to buy stocks more cheaply in the short term, whilst not risking the rest of your cash. If your investment horizon is long (e.g. 10+ years), then you realistically have plenty of time to weather short-term falls in performance and access a greater return in the future.
If you would like to discuss your financial plan with a member of our team, then get in touch today to arrange a free consultation:
020 8366 4400 or email@example.com.