If you invest relatively small amounts every month, or at least fairly frequently, you are benefitting from PCA ‘Pound Cost Averaging’. This is an investment strategy that won’t keep you awake at night when markets are particularly volatile. The strategy was first used in the USA and was known as ‘Dollar Cost Averaging’ or “The Constant Dollar Plan”.
When you invest a fixed regular amount, the number of shares or units you purchase will be higher when the price is low, and lower when the price is high. For the sake of clarity I will simply refer to units from now on but by this I include shares in companies or investment trusts and units in investment funds.
If you had invested a large lump sum you are likely to be discouraged and may have difficulty sleeping when the price of your units falls substantially. However, if you are investing a fixed amount each month, then when the price falls you will automatically purchase more units each month until the price recovers again.
Like any investment strategy there are situations when this can be useful to you and other situations when it is more likely to reduce the return on your investment. For example:
|When you can only afford to invest monthly (or at other regular intervals). If your goal is to build up a substantial lump sum over the long term for your future security, pound cost averaging is good news. In this situation your best strategy is to set up a regular, automatic investment plan and then forget about it. The plan will effectively handle the pound cost averaging for you. Provided that you do not need to withdraw money from your investment plan within the next five years then you do not have to be overly concerned about what the markets are doing in the short term.
When you have a lump sum to invest but because of concern over the markets you decide to feed this into the market over a period. If you are concerned that the markets may be going to fall substantially, then rather than investing a lump sum you could feed it into the market in smaller portions over, say, 6 to 18 months. In a falling market this will provide greater protection for your investment. However, if you are wrong in your view of the future direction of the markets then, of course, following this strategy will provide a poorer return. If your concern is the general volatility of the markets then it may simply be better to invest in a more defensive investment mix.
When you have a lump sum to invest but because of concern over the markets you decide to feed this into the market over a much longer period than 18 months. This is where pound cost averaging starts to lose its appeal. Whatever you may be thinking right now, the long term trend for stock markets is upwards. You are therefore normally better off investing a lump sum as a lump sum rather than investing smaller amounts over a period of time.
The effect on risk
Where you intend to invest monthly or at other regular intervals over a long period it is important to be aware that you can use somewhat higher risk funds than you would if investing a lump sum. This is because you do not have to try and ‘outguess the market’ – rather you can take advantage of the natural highs and lows of the market.
By investing a fixed amount monthly you automatically buy more units when prices are low and fewer when prices are high. The result is that the average cost that you pay for your units over time should be less than the average price of those units. The only time this would not occur is if the unit price remained constant.
| “As the financial markets heave and crash their way up and down day after day, the defensive investor can take control of the chaos. Your very refusal to be active, your renunciation of any pretended ability to predict the future, can become your most powerful weapons. By putting every investment decision on autopilot, you drop any self-delusion that you know where stocks are headed, and you take away the market’s power to upset you no matter how bizarrely it bounces.”
The Intelligent Investor by Benjamin Graham
Returns are linked to actual days
The returns that are available to you on unit linked investments don’t just depend on the investment performance of the funds in which you invest. Your returns also depend on the particular days on which the investment is effected or cashed in.
If the unit prices are low at times during the term of the investment this has no effect on your eventual return if you made a single investment. However, we have seen that low prices during the term of your investment can work to your advantage if you invest regularly. This is because your investment will purchase more units when prices are low than you are able to purchase when prices are higher.
By investing regularly you will receive a better return if unit prices are low for a long period and then rise before you sell the investment, than if the unit prices rise to the same eventual height at a consistent gentle growth rate. This is because you will have purchased units on average at a lower cost in the years of low prices.
Let’s consider some examples
Let me assume that you have decided to invest £6,000 a year for 10 years. In reality you are going to invest £500 a month but I have taken an annual investment as an example because a monthly investment would result in a very much longer calculation. I have ignored all charges for simplicity.
In this example I have assumed that your unit price rises at a constant rate for 10 years from 100p to 190p.
In this example you would have made a very useful total return of 36.57%. However, the pattern of the following investment is much more realistic than the constantly increasing unit price.
In this example I have assumed that your unit price fluctuates, going down and up for 10 years between 100p and 190p.
In this example you would have made an even better total return of 78.29%. So rather than suffering as a result of the volatility in the unit price, you would have gained by purchasing a much higher number of units overall.
We don’t need a table for this one. In this example I have assumed that you were able to invest the whole £60,000 at the outset and that the initial unit price of 100p and the final unit price of 190p were the same as in the previous examples.
In this case it is irrelevant what happened to the unit price in the interim period. In this example you would have received the highest total return of 90%. Of course, in such simplistic examples we cannot allow for the effects of inflation nor the interest you would have received by leaving your capital on deposit and transferring £6,000 into your investment each year.
The purpose is simply to show you that if you are prepared to invest monthly for the long term you need have little fear of volatile markets.
You can obtain the benefits of Pound Cost Averaging for any of your investment or pension plans which allow for regular investments. For example:
- You could invest monthly in one or more investment funds. This should ideally be done via an online investment platform which will give you the benefits of a very wide range of funds and administrative simplicity. Where possible you should do this via a Stocks and Shares ISA.
- You could contribute monthly to a workplace pension scheme or a stakeholder pension plan if a workplace pension is not available to you.
Past performance is neither a guide to, nor a guarantee of, future returns.
The value of your investment is not guaranteed and can go down as well as up, and you may not get back the amount you originally invested.
Pound cost averaging is not guaranteed to produce a profit for you or protect against losses in declining markets.
As pound cost averaging involves continuous investing regardless of fluctuating unit prices, you should consider your ability to continue purchases through periods of low price levels.
|If you would like to see what constitutes a successful investment process please follow this link https://usefulmoneyguide.uk/a-successful-investment-process/|