Pound cost averaging – how to avoid trying to second-guess market movements
The coronavirus (COVID-19) outbreak led to the biggest daily drop in the FTSE 100 on 12 March 2020, since the financial crisis. The FTSE 100 fell 9% when markets opened — worse than any single day in 2008 and beaten only by the record figures of 1987’s ‘Black Monday.’
Trying to second-guess the impact of events such as the coronavirus or the recent global stock market volatility – or even attempting to make a bet on them – rarely pays off and understandably can deter some people from investing.
Global stock markets, as we’ve seen, can be unpredictable and highly volatile. They move frequently – and sometimes sharply – in both directions. This is why it’s important to take a long-term view (typically ten years or more) and remember your reasons for investing in the first place. Investors need to be prepared to view the downturns simply as part of a long-term investment strategy and stay focused on their investment goals.
Avoidance of trying to second-guess market movements
Of course, it’s also important to remember that past performance is not a guide to what might happen in the future, and the value of your investments can go down as well as up. Market conditions, investor sentiment and other factors will cause prices to rise and fall – and this in turn affects the value of the capital that was used to purchase them.
Another option for more risk-averse investors over the long term is to save regular amounts, which enables the avoidance of trying to second-guess market movements. This method of investing is called ‘pound cost averaging’. You are effectively drip-feeding money into shares or units on a regular basis rather than committing a single larger lump sum, and it works by smoothing market volatility.
Reduce the risk of buying in highly volatile market conditions
Pound cost averaging is based on the principle that when markets are low, you acquire more for your money, and when markets are high, you acquire less. It is most often used with equity-based investments rather than bonds or fixed income assets that tend to be less volatile. The concept can apply to regular monthly investing as well as spreading the investment of a large lump sum investment over a period of time.
Regular or phased investments can also reduce the risk of buying on the wrong day and in highly volatile market conditions – as we’ve been experiencing – and it could mean that investors are able to purchase more units. This type of investing can more accurately be thought of as a series of lump sum investments, since the entire contribution is invested each period. Phasing can be achieved via an automated phasing facility or by instructions to switch from one fund to another over a period of time specified by the investor.
Instilling investment discipline no matter what the market is doing
To give you an example, one way to do this is with a lump sum that you’d prefer to invest gradually – for example, by taking £500,000 and investing £50,000 each month for ten months. Alternatively, you could pound cost average on an open-ended basis by investing, say, £5,000 every month.
This principle means that you invest no matter what the market is doing. Pound cost averaging can also help investors limit losses, while instilling a sense of investment discipline and ensuring that investors are buying at ever-lower prices in down markets.
Drip-feeding a lump sum investment into funds in regular amounts
Regular saving and investing is a highly effective way to benefit from pound cost averaging, and instilling a savings habit by committing you to make regular contributions. Regular saving is especially useful for investors who want to put away a little each month.
Investors with an established portfolio might also use this type of approach to build exposure a little at a time to higher-risk areas of a particular market. The same strategy can be used by lump sum investors too. Most fund management companies will give you the option of drip-feeding your lump sum investment into funds in regular amounts. By effectively spreading your investment by making smaller contributions on a regular basis, you could help to average out the price you pay for market volatility.
Taking advantage of market down days by regularly long-term saving
Investment professionals often say that the secret of good portfolio management is a simple one – market timing. Namely, to buy more on the days when the market goes down, and to sell on the days when the market rises. As an individual investor, it is likely that you may find it more difficult to make money through market timing. However, you could take advantage of market down days if you save regularly by taking advantage of pound cost averaging.
Historically, the overall direction of developed stock markets is a relentless and continual rise in value over the very long term, punctuated by falls. It’s important not to let current global uncertainties affect your financial planning for the years ahead. Individuals who stop their investment planning, particularly during market downturns, can often miss out on opportunities to invest at lower prices.
Market conditions are part and parcel of investing
Major events causing global markets to fall, particularly in the short term, is something we’ve seen time and time again. And it doesn’t mean that markets won’t recover, so try not to worry too much.
History shows again and again that the ups and downs of different types of market conditions are part and parcel of investing, and there have been many times in the past when events have caused short-term corrections.
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INFORMATION IS BASED ON OUR CURRENT UNDERSTANDING OF TAXATION LEGISLATION AND REGULATIONS. ANY LEVELS AND BASES OF, AND RELIEFS FROM, TAXATION ARE SUBJECT TO CHANGE.
THE VALUE OF INVESTMENTS AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED.
PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.