August 2006
  
   

POUND COST AVERAGING

We could summarise what many of our clients require of us by the statement “to use an investment process that will reduce the risk to capital whilst still allowing it to grow in real terms (ie ahead of inflation)." Such a process is ‘pound cost averaging’ and it is particularly useful to the more cautious investors and investors who can take a long term (10 years or more) investment view.

According to Warren E Buffett, one of the greatest investors in the world, Benjamin Graham’s The Intelligent Investor is “by far the best book on investing ever written”. In it Graham (who lived in America) states “Dollar cost averaging enables you to put a fixed amount of money into an investment at regular intervals. Every week, month, or calendar quarter, you buy more - whether the markets have gone (or are about to go up), down, or sideways.“

Let us use a simple example from an actual fund that can be repeated many times over. If you had invested a lump sum in the Invesco Perpetual International Equity Fund 5 years ago you would have achieved a return of just 1.4% pa compound (Money Management September 2006). However, if instead you had invested a monthly amount in the same fund during those 5 years your return would have been the equivalent of 8.19% pa compound.

By investing monthly you automatically buy more units when prices are low and fewer when prices are high. The result is that the average cost that you pay for your units over time will be less than the average price of those units. The only time this would not occur is if the unit price remained constant.

An Example

Let us assume that someone has £50,000 to invest for 10 years. They decide to invest, for simplicity, £5,000 a year, over the 10 years. All charges have been ignored for simplicity. We have also ignored the effects of inflation and the interest that would be earned on the balance of monies not yet invested.

Investment A: prices rise at a constant rate for 10 years from 100p to 190p

Beginning of Year
Investment £
Unit Price p
No of Units Purchased
1
5,000
100
5,000
2
5,000
110
4,545
3
5,000
120
4,167
4
5,000
130
3,846
5
5,000
140
3,571
6
5,000
150
3,333
7
5,000
160
3,125
8
5,000
170
2,941
9
5,000
180
2,778
10
5,000
190
2,632
Total Units Purchased
35,938
Total Unit Value = 35,938 x 190p = £68,282

The investor has made a good return. However, an investor who invested the whole £50,000 at the outset would have received much more, ie 50,000 x 190p = £95,000.

Investment B: prices fluctuate, going down and up for 10 years between 100p and to 160p

Beginning of Year
Investment £
Unit Price p
No of Units Purchased
1
5,000
100
5,000
2
5,000
60
8,333
3
5,000
80
6,250
4
5,000
90
5,555
5
5,000
70
7,143
6
5,000
100
5,000
7
5,000
90
5,555
8
5,000
110
4,545
9
5,000
100
5,000
10
5,000
160
3,125
Total Units Purchased
55,506
Total Unit Value = 55,506 x 160p = £88,810

The pattern of this investment is much more realistic than the constantly increasing unit price. The investor has made an excellent return because he has purchased 55,506 units over the period rather than the 50,000 units he would have purchased by investing the whole amount at once, or the 35,938 units in the first example.

In this case an investor who invested the whole £50,000 at the outset would have received noticeably less, ie 50,000 x 160p = £80,000.

You may wish to have a look at a new section of our website entitled Pound Cost Averaging.

Investment Advice

If you would like to discuss how pound cost averaging could assist your investment or pension planning please ask your usual Arch adviser, or contact us on 0845 3700 661 or enquiries@arch-fp.co.uk.

 

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