There is a discipline to saving which is often overlooked which can produce significant gains over time, and funnily enough, benefit from what most people fear – volatility.
When you invest a lump sum of money, there is a psychological battle wondering if you are investing at the right time.
Is the market about to fall? Should I wait? Well, no-one knows the answer to that of course, but that thought of the fear of losing out can paralyse us emotionally so much so, we don’t act.
Pound cost averaging is where you benefit from investing regularly rather than a one-off lump sum, regardless of the price.
You then purchase more units (I’ll explain) when prices are low, and less when prices are high.
When you invest into a ‘fund’ you are investing into a broad spread of shares.
Each of those shares has a value. That fund has a unit price which is a share in a spread of those stocks/shares, and the price moves up and down accordingly.
I’ll give you an example, and it’s just an example. You pick a good fund after speaking to your independent financial adviser and invest £1,200.
The unit price at the start was £100, so you bought 12 units (1200/100).
Your wife picks the same fund but decides to invest £100 per month for that first year.
In month one, her £100 bought one unit at £100 each. Just after investing, the shares in the fund become volatile and the fund’s unit price drops 10 per cent, then another 10, up five, up 10, up 10…and so on.
At the end of the year, it returns to the same price. Because you invested a lump sum, you had an emotional ride, but the return is zero.
Your wife smugly moonwalks into the room with a glass of wine with her valuation, which of course has outpaced yours, and she knows it.
That’s because in month two, when the market fell 10 per cent, she bought 1.11 units.
In month three, after another fall, she bought 1.25 units, month four 1.18.
At the end of the year, she has bought 12.79 units which have now come back to the £100 per unit price and are now worth £1,279.
The same money is invested with a different return and experience.
Assuming the fund choice is correct (and you need it to be), the fluctuations are celebrated by the monthly investor and feared by the lump sum investor.
This is counterintuitive for most of us but is great training for the mind.
‘There is no such thing as good or bad, it’s your thinking which does that.’
It is a good saying and very apt in this scenario. Such a strategy for saving/investing mitigates the risk of buying just before an inopportune time such as a downturn, it smoothes out the price over time reducing the impact of market fluctuations and takes advantage of them.
It also creates and encourages discipline and avoids emotional decision making.
You are less likely to make emotional decisions such as waiting too long or diving in when you think ‘it’s going up’.
You are more likely to think ‘the price has fallen, I will get myself more bargains by buying more units at a lower price’.
It is a strategy which is particularly good for higher risk funds where you are likely to get the higher returns but more fluctuation along the way.
The greater the price swings, the greater the potential for bargaining. On that basis, pension savings are worth re-considering.
If your attitude to risk is medium for a lump sum, is it the same for a monthly premium that you may be paying for 40 years?
Let’s also remember that you can invest into a pension for children from when they are born.
The pound cost averaging benefit for that would be enormous.
Similarly, ending the year with a lump sum ISA panic may not be as clever as a regular monthly premium to make up the annual allowance.
Peter McGahan is chief executive of independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. If you have a financial question for Peter, call 028 6863 2692.
