The Power and Risk of Pound Cost Averaging

Investing is simple. You’ve just got to buy assets when their price is low, so that you can sell them when their price is high. No, seriously, that’s all there is to it.

But you already know that just because something is simple, doesn’t mean it’s easy.

It’s why despite the vast amount of information available on YouTube, TikTok, blogs and podcasts, many (or maybe even most) investors struggle with how to implement such a straightforward concept. But there’s a solution.

Pound (or dollar) cost averaging is a strategy that just works. Over a long enough time frame, and with a diversified enough portfolio, drip feeding your funds into the market is a strategy that will make you wealthier.

But why does it work so well, and what are the risks of pound cost averaging?

What is pound cost averaging?

Pound cost averaging is the process of investing your cash in regular monthly intervals, regardless of market conditions. This means that every month you pay a regular amount of £500, £1,000, £2,000 or whatever is affordable to you over the long term.

This might sound like a simple strategy, and it is. Some might even call it lazy. But it’s actually much more clever than it might originally appear. 

The whole point of trying to buy in when an investment is cheap is to keep your average purchase price as low as possible. You know, the ‘buy low’ part we talked about above. 

If you invested in Coca-Cola stock right now, your average price would be around USD$60. If you waited and there was a further crash and the stock fell to USD$52 before you bought in, you'd have had a win with a lower entry price.

Pound cost averaging works beautifully, because you automatically buy more units of your investment when the price is low and less when the price is high. This stops investors from getting carried away and can make a big difference to the long term return of your portfolio.

The key is to put that money in every month, no matter what. If you start trying to get too clever, holding a little back this month and dropping a little more in the next, you will invariably make your returns worse.

That’s not a dig at you personally, it’s just facts. On average, retail investors who trade regularly end up with worse returns than those of the market as a whole, let alone those who lower their average price through pound cost averaging.

How Pound Cost Averaging Can Lower Your Average Price

We’ll use some really straightforward numbers for this example. Say you’re interested in buying an FTSE 100 ETF, and the current price is £100 per unit. You decide that you can put £500 per month aside to grow for the long term.

Great stuff, in your first month the £500 buys you 5 units of the ETF, with an average price of £100.

Now say next month there is a drop, and the ETF unit price goes down to £90. Your £500 goes in as normal, except this time you purchase 5.55 units. Then the same thing happens again next month, there’s a further drop and now the ETF is selling for £85 per unit. Your £500 this month gets you 5.88 units.

So, you’ve been investing for three months, you’ve paid in £1,500 in total and you’ve accumulated 16.43 units of the ETF. That means your average purchase price is £91.30.

Now when the market recovers back to where it was when you first started, the ETF will be back trading for £100 per unit. By pound cost averaging and lowering your purchase price, your 16.43 units are now worth £1,643. That’s a 9.53% return.

If you’d deposited the full £1,500 in one go, you’d have made nothing.

Not shabby at all.

Cashflow vs Lump Sum

There’s an important distinction to make here. Pound cost averaging works like a charm when it comes out of regular, future (ideally) cashflow. One of the most common questions we get is whether you should do the same thing if you’ve already got a lump sum of cash.

No, you shouldn’t.

Why? It comes down to opportunity cost. You’ve surely heard of this term before, and it simply means the thing you’re giving up on or missing out on by doing something else.

When it comes to investing, your opportunity cost is the thing you could have done with that money instead. While holding cash might seem like a ‘safe’ investment, the opportunity cost is huge. By sitting your money in a bank account earning next to nothing in interest, you’re potentially missing out on huge returns over the long term.

And what really seals the deal on this approach is that the stock market has more up days than down days. So over a long period of time, leaving money out of the market and trying to time it means missing out on more good days of gains than days of losses. Historically speaking of course.

So, lump sums that you plan to eventually invest anyway should generally be put into the markets as soon as possible. Not sure this applies to you? Maybe you have a specific set of circumstances or questions you need answering? Book a no cost call with us and we can discuss whether it’s the right approach for you.

This concept is the second reason why pound cost averaging works so well. We’ve talked about lowering your average purchase cost, and the other reason it’s a sound strategy is that it minimises your opportunity cost.

By placing your investable cash into investments right away each month, you’re not letting your cash build up and missing out on potential returns.

The risks of pound cost averaging

We’ve just spent this whole article explaining how it’s a fool proof strategy, and now we’re saying there are risks with it? What gives? Well just hold on, the reality is that the risks aren’t in the strategy itself.

It’s you. You’re the risk.

We all are. The ‘problem’ with a pound cost averaging strategy is that it is so simple. As humans, we feel the need to tinker and optimise and change things all the time. Sitting still and keeping things as they are doesn’t generally feel like the way to progress with our goals.

And that is the danger. By having an automatic, set and forget strategy, we can sometimes feel that we need to do something, especially when markets get choppy. It’s no different to a diet and exercise regime or learning to play guitar.

Keeping things simple and consistent is almost always the best way to achieve our goals, but keeping things simple and consistent is very, very challenging for many of us.

It’s why many investors achieve better results when they work with a professional like a financial planner. Sure, there’s making sure that the strategy is tax efficient and that the portfolio is optimised, but one of the biggest benefits is behaviour management.

As a third party, a financial advisor isn’t emotionally involved in your portfolio. They can maintain the strategy without feeling the primal pull from their subconscious to change things. They can look at a market crash and see it simply for what it is, without attaching a tidal wave of mental baggage that clouds their judgement.

Long term strategy over short term gambles

You’re unlikely to ever become the world’s greatest investor. You’ll probably never be able to analyse fundamentals like Warren Buffet or conduct technical analysis like a City hedge fund manager. But by utilising a pound cost averaging strategy, you don’t have to. 

By committing to your long term investment plan, and sticking to it every month, you’re guaranteed to buy more when prices are low and less when prices are high.

By just about any definition you can come up with, that’s a winning strategy for growing your assets. Our clients have been, quite frankly, shocked at the difference regular contributions make to their own financial projections, even with seemingly modest amounts of month.

If you want to see how pound cost averaging could impact your financial future, download our free app and use our free financial projection tools. You’ll be amazed with the long term potential.