A plus side to volatility
FIVE-MINUTE GUIDE TO... POUND-COST AVERAGING
INVESTING is riddled with jargon that intimidates beginners and excludes outsiders and one of the most impenetrable is pound-cost averaging.
This sounds complicated but the process is relatively simple, and most pension and stocks and shares Isa investors reap the benefits without realising it.
Pound-cost averaging can even help you turn recent stock market volatility to your advantage. So what does this ugly phrase mean?
If you invest a regular monthly sum, you benefit from pound-cost averaging without knowing it.
Say you invest £300 a month in a mix of investment funds or shares. How much stock you buy varies according to where share prices stand at the time.
So if they fall 3 per cent over the month, your £300 buys 3 per cent more shares.at the height of the global stock market crash in March, it might have bought up to 30 per cent more.
Myron Jobson, personal finance campaigner at Interactive Investor, said investing little and often has paid off during the pandemic: “It smooths out the short-term bumps and should produce a positive return over the long term.”
This is much less risky than investing a single lump sum, which could dramatically fall in value the next day.
Of course, it works the other way. If markets rise, your monthly payment buys less stock. So investors actually benefit from falling markets, but only if they recover before you start cashing in your pensions and Isas to generate income in retirement.
Most investors should reinvest all dividends for growth, during the “accumulation” phase of building their wealth.again, pound-cost averaging makes this more effective, as your reinvested dividends pick up relatively more stock when share prices are down.
New figures from wealth manager Brewin Dolphin show that somebody who had invested £100 a week from January would have had £2,657 by the end of June.
This is just £43 less than the £2,700 they paid in, despite massive stock market volatility in between.
While their money would have plunged in March, their regular weekly payments in April and May would have risen sharply as markets recovered.
By contrast, a lump sum of £2,700 invested at the start of the year would have fallen to £2,216, some £484 less than paid in.
Of course, when markets are rising strongly, as they have for the past decade, a lump sum will have fared better.
Financial planner Jo Douglas said pound-cost averaging softens the extremes of investing: “You may not get maximum returns, but it also shields you from significant losses.”
Investing regularly works best for big future events, like retirement, or saving for children and grandchildren: “Investing in the stock market is a long-term strategy and pound-cost averaging fits well into that.”
Tom Selby, senior analyst at AJ Bell, said regular investing removes the temptation to time the market: “Second-guessing markets is a fool’s game, especially today.”
Drip-feeding money also breaks your investments into manageable chunks and helps you budget around your salary.
Instead of worrying about a stock market crash, you might even welcome one.at least until you retire and start drawing money every month, rather than paying it in.