INVESTING EXPLAINED: What you need to know about pound-cost-averaging, an ideal way to limit the risk of investing in shares as a beginner
In this series, we bust the jargon and explain a popular investing term or theme. Here it’s pound-cost-averaging.
What is pound-cost-averaging?
Under this simple method of investing, you drip-feed money into the stock markets every month or every quarter, rather than entrusting a lump sum at the outset.
If, for example, you have a spare £3,000, you invest £250 a month, rather than staking the whole amount.
The aim is to limit the damage of falling stock markets by reducing the overall average cost of your investment, as each regular investment buys more units at times of market weakness, and fewer units when markets are high.
Spreading the risk: You drip-feed money into the stock markets every month or every quarter, rather than entrusting a lump sum at the outset
Who should invest in this way?
Pound-cost-averaging is an ideal way to limit the risk of investing in shares as a beginner. It is good to establish a routine – to ‘cement good behaviours’, as some would put it.
But it also suits seasoned investors who are wary about the direction of stock markets, but do not want to miss out on opportunities for gains – and also want to be positioned for an upturn.
They regard drip-feeding money into markets as a good discipline, acknowledging that you probably need to buy on the way down to benefit from a full recovery.
What is the chief benefit of this?
It removes some emotion from investing in stocks and shares – you are also more sheltered from volatility. You do not need to wonder if you’ve chosen the most propitious moment to buy. Instead, commit to regular contribution, whether prices go up or down. You should sleep easier.
Is there a downside?
Yes, if stock markets soar during the period over which you are investing it would have been more profitable to invest the whole £3,000. But at least you have derived some benefit – and spared yourself anxiety.
Where did the phrase originate?
The many advantages of this system were first popularised in The Intelligent Investor, an American book published in 1949, where it was called ‘dollar-cost averaging’ and described as a means of securing a ‘satisfactory overall price’ for your holdings.
The author of the book was Benjamin Graham. These days he is best known as the person that Warren Buffett, the manager of the mighty Berkshire Hathaway fund, regarded as his guru in matters of investment.
Buffett says his own philanthropy was inspired by admiration of Graham’s generosity with ideas, and much else.
Is value averaging different?
Yes. Under this system, you alter the amount you invest each month or quarter, contributing more if prices are declining. Some fans set a target for the growth of their portfolio, putting in more money if they are not meeting their goal. There is more work involved, and more risk.
How would I get started?
Most fund management groups offer monthly savings plans. You can also open an account with providers such as Nutmeg, choosing the level of risk you wish to take and your long-term goals.
Platforms (online investment supermarkets) like AJ Bell offer monthly saving stocks and shares Isas (individual savings account). The annual Isa allowance is £20,000.
Pound-cost-averaging can be a spur to make the most of this tax concession.