Pound Cost Averaging sounds appealing but rarely works in practice.
Pound Cost Averaging (PCA) means investing a fixed amount at fixed intervals of time. That's eminently sensible, if it means committing yourself to investing a fixed amount of your salary every month toward your retirement.
However, some people also think you should pound cost (or drip feed) a lump sum over a period of months. For example, if you had £12,000 that you wanted to invest in equities, they would tell you to invest £1,000 per month over a year, rather than investing the whole amount immediately.
Assuming your objective is to maximise gains for a given level of risk PCA is not a particularly sensible investment strategy. Put simply, there are better ways to invest.
Discredited by academic research
For forty years academic research has consistently shown that PCA doesn't provide returns above other strategies. The most cogent argument was given by George Constantinides, 30 years ago, in a catchy little paper called "A Note on the Suboptimality of Dollar-Cost Averaging". All available evidence supported the assertion that, "Replacing one major gamble on a temporary shift of prices by a number of smaller gambles" doesn't necessarily work.
More recently, in February this year, advisor Michael Edesess ran an analysis on 83 years of stock market returns. His finding was that investing a lump sum, on average, beat PCA by over 3 percentage points per year for one-, three- and five-year rolling periods.
Although PCA achieves lower returns, on average, than other strategies the research does show that it achieves this with lower volatility or risk. But this demonstrates nothing more than the obvious: to achieve higher returns you must accept higher risk. If you want to achieve lower risk, you can better achieve this by holding more bonds, or cash. And, in any case, why invest monthly? Why not quarterly, annually, weekly -- or plain randomly?
But Pound Cost Averaging remains fashionable
PCA is often recommended to lower risk investors with a lump sum. The easiest way to see why is to look at a simple example.
Suppose you have £2,000 to invest over four months (£500 per month).
- Month 1: Price £20, buy 25 shares
- Month 2: Price £10, buy 50 shares
- Month 3: Price £8, buy 62.5 shares
- Month 4: Price £20, buy 25 shares.
You have acquired 162.5 shares for £2,000, an average price of £12.31 (2,000/162.5).
However, the average share price over the four months was £14.50, being (20+10+8+20)/4. And your investment is worth £3,250 (162.5x20).
This apparent mathematical marvel achieves at least four psychological benefits that make it an easy (and in my view lazy) sell:
1. It avoids "regret", that the price declines 50% in the second month. In fact we are now "delighted" because we are buying more shares.
2. It confirms we were very "clever" to phase our investment and not buy at the market "top"
3. It satisfies our deep seated need to avoid loss. And our fear of loss is twice as great as our hope for gain
4. In an instinctive way it seems more "prudent" to spread an investment over months than take a "gamble" on a large one-off investment.
But, and it's a big but, there are three important reservations we should have about the sales pitch.
1. The sequence of prices is usually presented as in my example. But that sequence is not necessarily a valid, or even representative, trend. In fact the trend I have used is highly unlikely.
2. It is not logical. The only point in adopting PCA is because there is an implicit expectation of a fall in prices. If this is the case why invest in month one at all. Why not wait for a price decline before the first investment?
3. It is simply not the best strategy, in investment jargon it is sub-optimal. If you believe (as a PCA investor must) that it is a "good thing" to buy more shares when prices are low, why not invest more than an equal amount in each month of lower prices?
That third point highlights the critical weakness of PCA as a strategy; it focuses on investment instalments and not portfolio value. Fortunately there is a technique called Value Averaging (VA) which can wean you off PCA and boost returns if you must insist on drip feeding a lump sum.
Use Value Averaging instead
A VA strategy would take as its start point the situation described above – the desire to invest £2,000 over several instalments. From there on it differs fundamentally. The PCA investor's objective is to simply invest £500 per month. For the VA investor the objective would be to buy shares such that the portfolio value increases by at least £500 per month. So, using the example above the schedule of purchases would be:
Pound Cost Averaging
| Month | Market price | Investment | Shares bought | Portfolio value |
|---|
| 1 | 20 | 500 | 25 | 500 |
| 2 | 10 | 500 | 50 | 750 |
| 3 | 8 | 500 | 62.5 | 1,100 |
| 4 | 20 | 500 | 25 | 3,250 |
| Total | 2,000 | 162.5 | 3,250 |
| Average price | 12.31 | | |
Value Averaging
| Total shares | Portfolio value b/fwd | Investment | Shares bought | Portfolio value |
|---|
| 0 | 0 | 500 | 25 | 500 |
| 25 | 250 | 750 | 75 | 1,000 |
| 100 | 800 | 700 | 87.5 | 1,500 |
| 187.5 | 3,750 | 50 | 2.5 | 3,800 |
| Total | | 2,000 | 190 | 3,800 |
| Average price | 10.53 | | |
Because the VA investor is focused on increasing portfolio value, in the example above he is 'forced' to add 75 shares to his previous 25 to meet his valuation target of £1,000, when the price plummets. The PCA investor simply invests a further £500. The result is the value average investor buys more shares when they are cheap and less shares when they are expensive, and makes more money. That sounds a lot more sensible -- doesn't it.
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