Award-winning journalist Holly Black on pound cost averaging and the potential benefits for investors
Stock markets falling can present opportunity
"The best investors know that when stock markets fall, it is not time to panic. Instead, professional investors say this is often when the best opportunities present themselves.
When the value of a company’s shares or an investment fund drops, it can be a little like going shopping in the sales – you have the chance to buy the same thing you could a week or month ago, but at a cheaper price.
Fund managers say that when the value of an investment dips the first thing they do is go back to the drawing board and assess the so called fundamentals of the company. This means looking at everything from its balance sheet and management team, to its products and competitors, to work out if the reasons they initially invested still exist.
Sometimes they don’t – there might have been a profit warning at the company or a change in leadership. But if they conclude that the shares still look to be a good investment, rather than panic that the price has fallen, they rejoice: this is a chance to stock up at a bargain price."
Set up a regular investment plan
"However, having the nerve to invest when a share price is falling is easier said than done. This is why setting up a regular investment plan is, for many people, a good idea.
Regular investing plans allow you put as little as £50 a month into your investments automatically (just the same way as you might have a direct debit set up for your mobile phone bill or a standing order). Setting up such a plan means you do not have to remember to invest each month, when there are so many other bits of life admin to keep up with.
Many people will panic when the stock market falls and will hold off putting money into their investments until the volatility subsides, but this is often a mistake. These periods can be the best time to invest because prices are cheaper."
What is pound cost averaging?
"If you have a regular investment plan your money is automatically invested whether markets are soaring or spiralling and this means you benefit from an investment wonder known as pound-cost averaging.
The premise of this is that because you invest the same amount each month, you end up buying fewer shares when they are more expensive and more when they are cheaper. Over time this smooths out the price you pay for the investment. For example, if a company had a share price of £1 you would buy 50 shares with a £50 monthly investment. If the share price halved to 50p, you would pick up 100 shares that month. That means, if the share price recovers to £1, the value of your investment has grown and you have more to show for your money.
Investing in this way can help mitigate a major risk that comes with lump sum investing, whereby you put all of your money into an investment on a single day rather than drip-feeding it in.
There is a potential downside to pound-cost averaging, of course, and that is that you invest in a fund or share whose value continues to increase. In this instance, you will, over time, be paying more and more for the investment each month whereas if you had invested your entire sum at the start you could have paid less.
While you may indeed be better off investing your entire £20,000 annual ISA allowance on the first day of each new tax year, making monthly deposits allows people to get into a good habit of investing regularly, which may be a particularly helpful approach for those just starting out on their investment journey – it can be surprising how quickly small amounts can add up over the long term."