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A long term investment return trick: Pound cost averaging

by Sable International | Aug 02, 2011
  • We all know the current climate of volatile markets and scary newspapers has an effect on investor psychology. At worst decisions are delayed and investments sold when markets are falling. At best cash is accumulated and invested as a lump sum when markets settle.

    We all know the current climate of volatile markets and scary newspapers has an effect on investor psychology. I find it’s often the wrong effect. Investors become tempted to sit on cash and struggle to make decisions about investing. At worst decisions are delayed and investments sold when markets are falling. At best cash is accumulated and invested as a lump sum when markets settle.

    So I think it might be worth revisiting the most important investment principle in volatile markets and in long term investment strategies – Pound cost averaging. Simply put  this is when you invest a set amount every month into your pension or investment portfolio. When you do this you get a different set of prices for the underlying funds every month. If you’re investing say £100 (or any multiple of that) your £100 buys x number of units at today’s prices. If the market falls between this month and next your £100 will buy more units in that same fund  - because the entry price of that fund has fallen. So when markets fall you get the funds at cheap prices – the market is on sale! When the market is high (and hence overvalued relative to the long term average) your £ 100 buys less units. So this strategy allows you (in the long term) to accumulate units at an average price below the arithmetic average of the market. In the same way you’ve essentially used the volatility of returns in the market to boost your overall return.

    There is only one situation when investing a lump sum yields a better return (all other things being equal) than a pound cost averaging approach and that’s when the market goes straight up from the point you purchased. We all know markets always come down after they go up so in the long term the pound cost averaging approach invariably wins. So next time your adviser tells you to start putting £ 100 extra into your pension or your ISA you would be well advised to listen!

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