How pound cost averaging could potentially help counter inflation
- Shunil Roy-Chaudhuri
- 03 November 2022
- 5 mins reading time
‘Pound cost averaging’ (PCA) may not sound the most riveting topic. But it could potentially reduce the impact of stock market fluctuations and thereby lessen investment risk. Now that probably is of interest to most of us.
To see how PCA works, first imagine a company with shares listed on the stock market. Let us call the company Tazzler. Now imagine that its share price on the first trading day of three consecutive months is as follows:
Share price of Tazzler
Someone who bought 1,500 shares in Tazzler on 1 March, would have paid £1,650 for shares which would then be worth £1,500 on 1 May. So on 1 May this person, who I will call Investor A, would have suffered a loss on paper of £150.
But someone who bought 1,500 shares on 1 April, Investor B, would have paid £1,350 and, on 1 May, would have made a gain on paper of £150.
Investor C, who bought 500 shares on 1 March, 500 shares on 1 April and 500 shares on 1 May would have paid £1,500 for shares with a paper value of £1,500 on 1 May. In this example, which is for illustrative purposes only, Investor C would have paid the average price for the shares in the three-month period.
As at 1 April, Investor A would have had a paper loss of £300, while Investor C would have had a much smaller paper loss of just £100. On the other hand, Investor B would have made a £150 gain between 1 April and 1 May, but Investor C would have made nothing (which would not have been a significant concern, given the short two-month period).
Smoothing out the peaks and troughs
The crucial point is that Investor A and Investor B, who invested single £1,500 lump sums, saw greater swings in value, both upwards and downwards, than Investor C, who made three monthly contributions. This is because Investor C benefited from pound cost averaging (PCA), which can smooth the peaks and troughs of investment returns and thereby potentially reduce investment risk.
In simple monetary terms, Investor B, who paid just 90p for the Tazzler shares, had the highest returns of the three investors. Unfortunately, it is very difficult to pick the right time to invest, which is why at SPW we say investing is about time in the markets, rather than timing the markets.
We also believe in the power of diversification, of ensuring your investment eggs are not all in one basket. So we generally advise investing in a diverse range of assets held for the long term in line with your particular circumstances, rather than in one single company.
Even so, markets in general have ups and downs and PCA can potentially help reduce the impact of these fluctuations. But PCA might not be right for everyone and a good financial adviser can look at your overall situation and assess whether or not it might be suitable for you.
PCA is, though, another tool in your investment armoury. And, at a time when inflation is eating into investment returns, we need to consider all the tools at our disposal.
The value of investments and the income from them can fall as well as rise and are not guaranteed. The investor might not get back their initial investment.
Any views expressed are our in-house views as at the time of publishing. This content may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.
Fees and charges apply at Schroders Personal Wealth.
There is no guarantee by investing money it will keep level or beat inflation, particularly when inflation is high.
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