What is pound cost averaging and why is it important?

Published on 14 November 2018

James Henderson, fund manager of Lowland Investment Company and Henderson Opportunities Trust discusses how to put money to work in the markets on a regular basis.

Investing in shares of companies is seldom straightforward. It involves lots of unknowns and after a period of time you will almost certainly face some surprises. For decades, investors have employed principles and strategies when investing in order to achieve their desired returns and simplify the investment process into a trusted methodology.

There are plenty of strategies and approaches to investing; some are complementary with one another; some can be polar opposites; and some require greater effort and time than others. The trick is to find one that suits your appetite for risk-taking, personal life and investment goals. This blogpost will focus on one strategy that aims to reduce some of the decision-making, known as ‘pound cost averaging’.

Pound cost averaging is the effect of putting a regular amount of money into an investment on a prearranged day, typically once a month, over an extended period – usually years. The money goes in on the day regardless of rain or sun, which means the desire to time a purchase is taken away.

It rarely feels the right time to make a lump sum investment. When the investment background is benign and companies are coming in with good results, share prices are unusually high. When the values of companies are low, the economy is usually facing real difficulties that can look very daunting, so it is tempting to put off doing any investment until some of the economic worries subside. By the time they are better, share prices are usually substantially higher. Therefore, investors have to be brave and fortunate if they are to ‘time’ the market and achieve optimal returns. Many investors believe in shares for the long term, but they never hold enough of them.

After all, markets are a discounting mechanism, which means that at any given time a share price takes into account what is publicly known or thought about a company’s future prospects. The problem for investors is to understand how much of the future has been correctly priced into a share price. This is very difficult if not an impossible task to consistently do well. There are too many variables that are constantly changing. A great many computers are working with advanced algorithms to do this and still find it impossibly difficult, so the individual has little chance. The way round this problem is to invest by doing it on a regular basis in relatively small size. The benefit is that the emotional swing of investing goes out of the decision. This is important as the human behaviour overlay to an investment decision often detracts value.

Humans are swept up by herd instinct. It is more comfortable to go with the crowd, yet we know the crowd’s instinct in investment is to respond to already discounted news. The innate behaviour-biases of humans often anchor a person to the recent events and current prices, rather than thinking through where things are going to be tomorrow.

People are inclined to react to events rather than predict them, while market prices quickly discount the recent news and want to “price in” what lies in the future. Therefore, regular small scale buying reduces the tendency of buying at the wrong time and it allows the investor to enjoy the effect of getting an average price over time, hence ‘pound cost averaging’.

Shares have historically been the best asset class over a long period of time[1] and regular buying is one strategy that aims to exploit markets over the long-term. The pound cost averaging approach is a strong investing discipline and it seeks to remove misguided human bias from the decision-making process.

[1] Barclays Equity Gilt Study 2016: https://www.allocationblog.com/content/uploads/sites/3/2016/07/Equity-Gilt-Study-2016.compressed.pdf