Pound cost averaging. If you’re a normal kind of savvy woman, it’s probably not a phrase you use on a regular basis, but it’s worth understanding what it means and when it could benefit you, if you’re thinking of investing. In its simplest, it means that if you drip feed money into the stock market, because the price of shares rises and falls, you may win overall because your money buys more shares when the stock market is low (and vice versa). How?
The basics of pound cost averaging
If you were to invest a regular amount in, say a pooled investment fund (such as a unit trust or an investment trust), ‘pound cost averaging’ would give you two benefits:
– When prices are low; your money goes further. Say you invest £100 a month, when share prices are low your £100 will buy more than when they are high.
– When prices are high; your money buys fewer shares (or units, if it’s a unit trust you’re investing in).
SAVVY TIP: It sounds like it should all even out, but because you buy more shares or units when prices are low, and fewer when prices are high, the average price you pay will be more than the average price of the shares/units throughout the year.
Advantages of regular payments
If you pay regular, monthly amounts into your investments, you will cushion the worst effects of the stock market volatility, although you could also lose out on the best possible growth as well. Here’s why:
– If you were to pay in a £1,000 lump sum and the stock market were to fall: the whole of your investment would fall in value. If, on the other hand, you were to pay in £100 a month and the stock market fell for four months after your first payment then began to rise, six of your monthly payments (£600) would not be affected by the fall in share prices.
SAVVY TIP: The shorter the period that you pay in your regular payments, the lower the impact of pound cost averaging. So, if you feed in your £1200 lump sum over four months, you’ll get less benefit than if you pay it in over 12 months.
– If you were to pay in a £1,000 lump sum and the stock market rose immediately afterwards; you would get the full benefit of rising share prices. This is one scenario where ‘pound cost averaging’ wouldn’t help you. However, it’s pretty difficult to work out when the stock market has reached its lowest point.
SAVVY TIP: Investors have a habit of waiting until they are sure the market is rising (because it rarely falls one day, and starts steadily rising the next, there’s often a period of ups and downs in between) before they invest. This means that, even if they invest with a lump sum, they rarely time it so well that they catch the stock market just as it is starting to rise.
When a lump sum payment may be better
Having said that regular sums being drip fed into the stock market is normally a better idea than paying in a lump sum, that’s not always the case. The Association of Investment Companies, which represents investment trust companies, has done some research that shows that while pound cost averaging comes into its own in volatile markets, over the longer term, if you’d paid in a lump sum on day one (rather than making regular payments), you’d do better.
SAVVY TIP: The comparison is slightly unfair in that if you had the money to invest, but chose not to, you’d probably put it in a savings account so would earn interest on it.
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