Benefiting From Volatility: Pound Cost Averaging
March 20th, 2007
Recently I spoke about doing nothing in uncertain markets, and I’d like to continue the theme of stockmarket uncertainty by talking about ‘pound-cost averaging‘.
In volatile markets it is quite understandable to be concerned about the value of your investments. However, it is possible to make market volatility work for you. Regular investing, usually monthly, and phasing, drip feeding a lump sum into an investment over a number of months, can work to your advantage in volatile markets.
The main benefit of investing regularly is known as ‘pound-cost averaging’. Don’t let this complicated term confuse you as the principle is quite simple really. If the market does fall, then you know that your next monthly investment will benefit from the higher number of shares you will be purchasing at the lower price. Of course, in a rising market, this will result in less shares being purchased but then your existing shares should be showing a profit.
Over a period of a few years, pound cost averaging means that the average price paid can be lower than the average share price for that period since more shares are bought when prices are low and fewer when prices are high.
How does it work?
The diagram below shows how the share price of a theoretical investment (represented by the dots) can fluctuate over time. As can be seen from the bars, an investment of £100 per month buys a lower number of shares when the share price rises but a higher number of shares when the share price falls.
The illustration below shows how a regular investment of £100 per month invested in UK shares over the last 10 years would have performed against a lump sum investment of £12,000 (i.e. £100 x 12months x 10 years). Whilst investing a lump sum upfront ultimately resulted in a better overall return, investing monthly produced a much smoother return, helped by pound cost averaging reducing the affects of market volatility. The falls in the market between 2001and 2003, meant that the regular investment of £100 purchased more units which helped to boost the investment value when the market recovered.
You should be aware that the value of investments and the income from them can go down as well as up and you may not get back the amount invested.
No need to time the market
We all know that markets can go up and down but often these movements can be quite extreme. In volatile markets, investing regularly or phasing means that you don’t have to worry so much about putting all your money into shares just prior to when prices may fall.
Please note that past performance is no guide to future returns. The value of units and the income may go down as well as up.
Author: Philippa Gee
March 20th, 2007
Category: Investments.
