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The Myth of Pound Cost Averaging

Below is an excerpt from FPP Director, Patrick Waller’s book: “Life’s Too Short Not To Do Crazy Stuff” about the myth of pound cost averaging. Click here to request a copy.

Pound

The Myth of Pound Cost Averaging

“This is an old chestnut that often appears in those money makeovers you see in the newspapers or the financial advice columns in the press, often by so-called experts. Sacrilege I hear you cry! Pound cost averaging; the saviour of the regular saver. Nope.

Sorry.

Pound cost averaging works, but only in a narrow range of circumstances. It is, in general, irrelevant – and here’s why.

For those who have not heard of this phenomenon it goes something like this. If you invest in shares in Widgets PLC and you are not sure if the price of the shares is going to go down (or up for that matter) then why not buy a few shares each month? The supposed magic then happens like this:

Suppose I decide to invest £100 a month in shares in Widgets PLC and in month one the shares are £1 each. It therefore follows that I get 100 shares. Alroticsoli . Right so far. Hang in there.

Then in month two I invest another £100 but, horror of horrors, the shares have halved in value (and price) to 50p, and I shout “sacre bleu” as I realize that my month one shares are now worth a paltry £50. However I console myself in the knowledge that in month two I buy 200 shares for my £100.

In month three, double sacre bleu. The market in Widgets PLC shares collapses further to 25p a share and my month one shares are now worth a big, fat 25 quid. EEK! However, undeterred, I trudge onwards to my financial doom and carry on investing but console myself with picking up 400 shares in month three at 25p a pop for my 100 quid.

Then the light bulb gets replaced at the end of the pound-cost-averaging-tunnel and the shares recover to £1 each. So I am somewhat happier that my £100 has now bought 100 shares.

Then in month 5 someone turns the light bulb back on and the shares increase in price to £1.25.

Phew! I now have 880 shares for which I paid £500 but now those very same shares are worth £1.25 each so my investment is now worth £1,100. Incroyable! (I have no idea why I did that in French). I’ve made £600 due to the miracle of Pound Cost Averaging. (In case you hadn’t guessed it, this example is exaggerated to make the point.)

It works! We’re saved!

Well, yes and er, no.

And here’s why. (Sorry to pierce the bubble.)

The first bubble-piercing fact is that yep, it works but it also works exactly the same but in the OPPOSITE DIRECTION in a RISING market!! To make PCA work you need a falling market for a fair amount of time (1/2/3 years) followed by a rising market. Yet again, that’s trying to call the market – and do NOT try to second-guess the market. That’s called “a waste of time and energy”.

But that’s not all. Here’s more bad news for the Pound Cost Averaging disciples…

Let’s use an example.
Suppose you put £1000 a month in to your shares/unit trust/ISA/whatever and the price fluctuates. The price goes down. You call your financial planner and shout “yikes”. Never fear says he, it’s fine because of pound cost averaging.

Now let’s add in another piece of information. You are investing £1,000 a month and YOU ALREADY HAVE £200,000 IN THE FUND. If the price of the units/shares you are buying has just gone down by 20% do you REALLY CARE that your £1000 per month is buying shares at a 20% discount. No you bloody well don’t, I would suggest. What you REALLY care about is the fact that your £200,000 has just gone down in value by £40,000! Who cares that you saved

Ouch.

So here’s the rub. Pound cost averaging has an effect, but ONLY in the early stages of a regular savings plan in to an asset where the price fluctuates. Eventually the fluctuation in the price of the share/units is of hardly any relevance. And it ONLY works if the price falls initially and then rises. If it goes the other way it works against you.

Sorry folks, it’s all down to mathematics.

Therefore the simplest solution is always the best. DON’T try to outsmart the markets. Define your plan, your attitude to risk and your asset allocation (which eggs in which baskets), buy low cost funds that capture the market to do the required job and then park it. Go for lunch, play golf, go on holiday, spend time with your (grand)children, work through your bucket list. These are all a better use of your time.

What’s important is time IN the market, not TIMING the market. For example, if we look at the past 10 years for the MSCI World Index from December 2002 to December 2012 – if you had stayed invested the whole time your return would have been 68.96%. If you had missed the best 30 days your return would have been -49.08%. world domain names If you had missed the best 20 days your return would have been -32.19%, and -4.64% for the crime of missing only the 10 best days.

So missing the best 10 days would have cost you a return of 73.60%.

The Solution:

Stick to simple stuff. DON’T try and second-guess the market. By all means invest on a regular basis but what you need is a sound fund with the correct risk characteristics for your emotional state, your plans and your requirements. If you try to second-guess the market, you will usually be right about half of the time. The trick is to get in to the market with a correctly constructed investment portfolio and enjoy your spare time instead of trying to outsmart the market. We call this “stupidity prevention”.

If you use this stuff in your planning you will win the investment game. You’ll irritate a lot of people along the way, such as fund managers, bank managers, but who cares? It’s YOUR money. Invest it wisely and then spend it. Enjoy it. That’s what it’s for.

A lot of people will urge you to put some money in a bank and in fact – within reason – this is very good advice. But don’t go overboard.

Remember: what you are doing is giving your money to somebody else to hold on to and I think that it is worth keeping in mind that the businessmen who run banks are so worried out holding on to things that they put little chains on all their pens.”

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