Many of you will no doubt be aware of the term “pound cost averaging” when it comes to savings and investments. However, for those who are not familiar with the term a brief explanation would be appropriate as it can form an essential part of someone’s investment strategy.
“Pound cost averaging” tends to be focused on saving money on a regular basis but can be used when it comes to investing a lump sum, but we will look at that a little later.
Firstly, let’s look at how “pound cost averaging” may work to your financial advantage. When you save in unit trusts, you buy units in a particular fund or funds so let us assume that you set up a unit trust savings plan to save £100 per month and the cost of each unit are £1 on the day you make your first deposit.
You do not need a calculator to work out that your £100 will get you 100 units, so your trust is worth £100 ignoring any charges. However, by the time your next £100 goes in the next month the unit price has dropped to 50 pence. So your next £100 will buy you 200 units. The value of your unit trust is now worth £150 that is calculated based upon 300 units of 50 pence each. When your third month’s £100 is used to buy units the cost of the units has gone back to £1 so you now have 400 units with a value of £400 yet you have only saved £300 - not a terrible return!
The above example may seem a bit harsh as far as the fluctuating price of the units is concerned but is merely used to illustrate what “pound cost averaging” is.
So, as you can see, the benefit of pound cost averaging is that it spreads your risk when saving on a regular basis. It “averages” out the ups and downs of fluctuations in the performance of the stock market going some way towards providing a natural protection against such changes.
What is perhaps, not as commonly known is “pound cost averaging” can also be used when it comes to making a lump sum investment. Let’s assume that you have £5,000 to invest in unit trusts. Most people would invest the entire amount at one go, but there is absolutely nothing to stop spreading that investment over a number of months. For instance, you could dump say £1,000 every month for a period of five months.
However, needless to say, there are no guarantees that the value of your investment over say five years will have a greater value than the amount that has been saved or invested over that period but “pound cost averaging” does perhaps provide the opportunity to extend your risk just that little bit more. Yes, it could work against you dependent upon the price of the units when you make your deposits, but that is a chance that you take.
Scott Bryan, formerly a high street bank manager for over thirty years, he now works as a freelance financial writer when not consulting for Profile private wealth management software.