How to Generate Smoother Stockmarket Returns
November 2005
THE biggest problem facing all investors in the stock market is timing. As many of us know from experience it is very possible to be right about the future direction of a share price or market, but we actually lose money on the deal because our timing was off.
In fact, timing is so critical and so important that many of the best investors throw in the towel when it comes to timing. But this does not mean they give up, rather drip feed money into the market at regular intervals so as to get average prices.
Pound Cost Averaging
- Pound cost averaging smoothes out returns over a period of time
- For example, if you wanted to invest £1200 in Vodafone for the longer term you could buy all the shares today or wait for a better price sometime in the future
- But then of course the risk is that the better prices never come
- Sods law also states that if you buy £1200 of Vodafone today the price will move lower in the future
- Correctly trying to time the market usually only leads to frustration
- Pound cost averaging attempts to remove the frustration levels and get an average buying price of a stock over a set time period
With the Vodafone example buying £200 of shares per month for six months is an example of Pound cost averaging. However, with small amounts of money it is always sensible to work out the costs involved because unless you are investing with very low commissions the costs can really build up. Commissions and other charges are not such a factor when investing in chunks of around £2000 plus.
With Pound cost averaging you will be buying more shares when the price goes down and conversely buying less shares if the share price rises.
Regular Investing In Investment Funds
Pound cost averaging works best with long-term investments and is therefore especially suited to putting money to work in unit trusts and other types of investment funds.
The process also works well when you do not second-guess the precise time to invest and also invest with a regular amount. For example, if you like the prospects that both the Indian and Chinese economies have over the next 10 to 20 years then setting up a direct debit of £50 per month to invest in a couple of funds would be a prudent approach. Investment management companies are set up just so these types of regular payments can be accommodated by their clients (see the Fund Supermarkets link below)
Summary
Pound cost averaging has been around for as long as the markets have been in existence so the strategy is hardly revolutionary. But it is very effective and is one which is adopted throughout the investment community. It is especially useful for those investors just starting out.
As we suggested in the opening paragraph timing is the nemesis of most market participants. The shrewd investors know and understand this, and therefore concentrate more on where to invest their money rather than wasting effort on trying to find the exact best time to invest.
See Also
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