InvestingStrategies

Pound-Cost Averaging: Best Passive Investment Strategy?

What Is Pound-Cost Averaging (PCA)?

Pound-cost averaging is an investment method that decreases the overall volatility on purchasing equities and securities by spacing out investments over equal periods of time. Pound-cost averaging is a smart investment strategy for risk-averse investors who have long-term investment goals.

Across the pond, they call it dollar-cost averaging, for, well, obvious reasons.

Pound-Cost Averaging: In Practice

Here is a scenario: Imagine you suddenly come into possession of an extra £100,000.

If you have been following our advice on previous investment advice posts, you probably know by now that investing is a great idea to build wealth.

So, naturally, you may be tempted to invest that entire £10,000 in the stock market.

Further, let’s say that you invest that entire £100,000 all at once into stocks priced at £100 a share.

At the end of the year, a financial recession has caused the price of each share to drop to £80, so overall you have a 20% loss of £20,000.

Now imagine the scenario again, but say you spaced out your £100,000 investment over the course of a year; let’s say £25,000 each quarter.

As the stock value goes up, you buy fewer securities, and as it goes down, you buy more securities. So you end up with more shares and a decreased average share price.

Now, instead of holding 1,000 shares price at £80 a share and having a £20,000 loss at the end of the year, you have 1,200 shares valued at £96,000 a year, only a £4,000 loss.

As the stock value goes up, you buy fewer securities, and as it goes down, you buy more securities. So you end up with more shares and a decreased average share price.

Now, instead of holding 1,000 shares price at £80 a share and having a £20,000 loss at the end of the year, you have 1,200 shares valued at £96,000 a year, only a £4,000 loss.

So, what happened?

In both cases, you invested the same exact amount of money, yet in the second scenario, you were much better off than in the first scenario. The answer is that in the second scenario, you used an investment strategy that is called pound-cost averaging. Let’s talk a bit more about pound-cost averaging and why it is a smart passive investment strategy.

Pound-Cost Averaging: How Does It Work?

Pound-cost averaging (PCA) is an investment strategy characterized by spacing out total investments over equal periods of time, rather than investing all at once. The point of pound-cost averaging is to mitigate the negative effects that a volatile market can have on your investments.

For example, say you dump a whole bunch of money into some company shares all at once. If the value of those shares drops, since you bought all of them at once, you will see a greater overall decrease in your invested amount.

If you had instead spaced out equal payments over some period of time, these effects could have been mitigated.

Since the amount invested is the same each investment period, when share prices rise you get fewer shares and when it lowers you get more shares. PCA removes the need to exactly time the market to buy and sell equities at their optimal values.

In fact, many people already use PCA even if they may not realize it as such. If you have a pension fund through your employer, then your regular contributions could be considered a form of pound-cost averaging.

The key insight that makes PCA a passive form of investment is that the periodic investment amount is not sensitive to market conditions.

In that sense, PCA can be seen as an alternative to momentum and contrarian investment strategies which are considered more active forms of investing.

With PCA, investments take place at fixed time periods in fixed amounts.

By spreading out the costs over a period of time, investors can insulate themselves against future market changes. During times of poor stock performance, PCA helps because it exposes only a part of the total sum to the decline.

Overall PCA can make your total average cost per share lower than it would be if you invested everything in one lump sum.

Benefits of Pound-Cost Averaging

Time In Market > Timing The Market

In an ideal world, investors would have perfect knowledge of when share prices would rise or drop so they could then maximise their buying and selling behaviour.

Unfortunately, we humans are far from omniscient though and attempts to “time the market” often backfire, sometimes spectacularly.

PCA involves making periodic investments of equal amounts regardless of current market conditions. Such a strategy decreases the incentive to try and time the market.

PCA Takes Emotion Out Of Investing

One problem that PCA supposedly alleviates is human being’s tendency to let emotions and prejudice dictate their investment behaviour.

It is a common saying in economics that the two things that drive markets are human greed and fear. When share value drops, investors get scared and start to sell, but they might miss out on potential future gains when the market recovers.

Conversely, when share value is rising, greed incentivizes people to buy more, which can make the shares overvalued.

PCA Limits Your Losses

PCA also helps limit your losses in the face of inevitable market declines.

No matter how savvy of an investor you are, you will go through periods where you see the value of your shares decline; it’s an unavoidable part of trading.

Instead of diving headfirst and investing all your money at once, PCA lets you “wade” into the waters so you don’t get completely crushed by unexpected waves (to continue the water metaphor).

While pound-cost averaging is usually portrayed primarily as a means to insulate yourself against unexpected market losses, it can also be a stable investment strategy for building wealth.

Sustainable Long Term Growth

In general, markets tend to exhibit an overall increase over long periods of time. PCA lets you take advantage of this universal trend and sets you up for sustainable long-term growth.

PCA is definitely not a get rich quick scheme; it requires patience and a kind of stoicism in the face of downturns. But, it is an extremely smart low-risk strategy for long term gains.

One problem that PCA supposedly alleviates is human being’s tendency to let emotions and prejudice dictate their investment behaviour.

Downsides of Pound-Cost Averaging

Lower Risk = Lower Reward

Risk in stock trading is a double edge sword. When you take a risk and it goes poorly, then you get hurt.

However, if you take a risk and it goes well for you, then you can make out like a bandit. If you never take any risks, you won’t get hurt but you won’t necessarily come out on top either.

One potential downside of PCA is, since it eliminates a substantial amount of risk, it also eliminates the potential for substantial rapid gains.

Since PCA is usually interpreted as a strategy aimed at long-term growth, this is necessarily a problem, but it may not sit well with investors who are willing to take bigger risks to secure larger more immediate gains.

Lower Velocity Of Gains

Additionally, if a market is doing particularly well, PCA can actually lower your total potential gains. If you invest a lump sum earlier, it will do better than small investments over time if the market shows continual growth.

Also, since you are making more investments, PCA strategies can rack up more brokerage fees, unless you are investing in an index fund that does not have commission fees.

Some Call It ‘Too Formulaic’

Some criticize PCA for being too “formulaic” and say that it incorrectly downplays the pivotal role that human intuition plays in navigating stock markets.

This seems to be more of an aesthetic critique though and is not necessarily a claim that PCA does not work or doesn’t do what it is supposed to do.

Bottom Line

Overall, PCA is a smart passive investment strategy that is best suited for novice investors or those who want to keep risk as low as possible.

Although primarily designed to insulate yourself against market losses, using PCA strategies with smart investment decisions can be a potent method of building long-term wealth.

Tom
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About author

Fully qualified CISI Investment adviser for 5 year. Managed UK private client portfolios.
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