British investors love exchange-traded funds, or ETFs for short. The London Stock Exchange reported in September that the value of all ETFs listed on the LSE recently topped £902 billion.
ETFs are a popular product in part because they’re a sound match for the ‘pound-cost averaging’ investing approach. In this article, we’ll explain what pound-cost averaging is, its benefits, and why ETFs are a common investment choice by its followers.
What is pound-cost averaging?
Pound-cost averaging, also known as drip-feeding, is the technique of buying market-linked investments, such as shares, bonds and funds, gradually over a long period of time. For example, you could invest £100 in an ETF every month, regardless of whether the share price has gone up or down.
The term ‘pound-cost averaging’ emphasises the fact that by making many separate investments at different times, your total cost per share will become an ‘average’ of all prices you have bought at. Your investment success will no longer hinge on whether you bought on the right day or at the right price. Only the long-run price of that security will matter.
While market prices can rise or fall dramatically from week to week, a long-run average will barely move. This point becomes critical when you consider that total investment return is measured as the final price compared to the average cost paid. Therefore, the average cost is incredibly important to the financial success of investing.
By utilising pound-cost averaging, investors can expect a more typical return because their cost baseline behaves in a more stable manner.
What are the benefits of pound-cost averaging?
1. Earning a typical return
Few investors begin their financial journey hoping for a ‘typical outcome’. They actually aim much higher – targeting to ‘beat the market’.
We could possibly call this hubris or even naivety because the average retail investor actually underperforms the average stock market return by a disappointing margin.
By shooting to score a big win, investors engage in behaviours that erode their portfolio and impact their long-term expected return. These behaviours include over-trading (racking up tremendous trading commissions for their broker) or spending time out of the market – potentially missing out on dividends and returns while hoping for a financial crash to validate their gamble.
This is a great shame for a nation of investors because even the ‘typical’ returns of the global stock market are excellent by any standard. Analysis by asset manager Vanguard reveals that global shares have delivered an impressive 9.3% compounded annual return since 1993.
By aiming for ‘average’, you are essentially betting on the success of business rather than your ability to predict short-term news that impacts the stock market. Through ownership, you plan to capture the growth in value of many large enterprises as they expand and develop new products over the long term.
It is a simple play, but one that is easy to overlook when financial media and marketers continue to peddle the myth of ‘easy trading profits’ to new investors.
Pound-cost averaging means that you will occasionally buy at times when animal spirits (and therefore prices) are high. These purchases may deliver a lacklustre financial return. However, by investing on a schedule, you can rest assured that you will also buy at times when confidence and prices are on the floor. It is the offsetting impact of these contrary examples that explains why pound-cost averaging is favoured by so many investors.
2. Satisfying your risk aversion bias
Consider two scenarios that might unfold in the week after investing your life savings in an ETF on a single day.
- Scenario A: The price rises by 10%
- Scenario B: The price falls by 10%
Which scenario would produce the more extreme reaction? Would it be the elation of making a good call or the depression of having apparently ‘deleted’ 10% of your hard-earned money?
Numerous studies have shown that experiencing a loss has a disproportionate impact on our mood and well-being compared to profits. This is why it is logical that most of us have an aversion to risk. We don’t weigh the possible upsides and downsides equally. Therefore, we often try to avoid choices that could lead to disaster.
Pound-cost averaging is a technique that can bring some comfort to this part of our psyche in an uncertain investing world by neatly taking the worst-case scenarios off the table.
By its own mathematical definition, the average of a collection of different price points will lie somewhere in the middle. This means that a pound-cost average investor cannot possibly invest their entire lump sum at the very worst moment, such as at the top of a booming market.
To apply this concept to a real-life example, let’s consider an investor who applied pound-cost averaging during the dot com bubble of the late 1990s. They will have bought:
- Cheap stocks before the mania began
- Mid-priced stocks as they began to rise
- Overpriced stocks as the market hit an all-time high in March 2000
- Cheap stocks after the bubble popped
It is likely that the average price paid over this period will have still yielded a painful paper loss in the late 2000s as the bubble burst. However, by averaging the cost over a full cycle, our investor would have stayed well clear of the worst-case scenario (investing their full portfolio at the top of the market).
A pound-cost average investor can never score an epic win. But this is a trade-off that many feel is worthwhile, considering our very human aversion to risk.
Why pound-cost average using ETFs?
ETFs are the natural choice for pound-cost averaging because they represent a continuation of the same philosophy of risk aversion. It’s another application of ‘averaging’ but over a different dimension.
Investors looking for a typical return with the pound-cost averaging method are diversifying over many price points. But ETFs also allow investors to add breadth to their portfolios by diversifying across many independently priced securities.
It’s useful to visualise pound-cost averaging as diversification on one axis and ETFs as diversification along another axis. They compound upon one another to reduce risk and produce an investment experience that sits closer to the long term average of the whole market.
- Pound-cost averaging reduces the risk that you invest at the wrong moment
- ETFs reduce the risk that you pick the worst asset
ETFs are also cost-effective to purchase little and often, with zero-commission offerings available, such as on InvestEngine. This makes them a suitable vehicle to drip feed savings into on a weekly or monthly basis without losing a portion to fees.
Conclusion
By spreading out ETF purchases over a long period of time, investors can leverage the power of the ‘boring’ average. By effectively investing at the long-term average price, investors will avoid the relative highs and lows that could have resulted in being wedded to a single entry point.
Pound-cost averaging does not reduce the risk of investing to zero, nor does it eliminate the possibility of incurring a significant loss. However, it can bring investors much closer to the long-run price performance of a security. By coupling the strategy with broad, index-based ETFs, this then applies to the stock market as a whole.
In a nutshell, it’s a compelling yet remarkably lazy approach to investing that is taking the UK by storm!
Written by the team at Koody for InvestEngine. This article is merely informational and does not aim to give financial advice. Capital at risk when investing.
Important information
Capital at risk. The value of your portfolio with InvestEngine can go down as well as up and you may get back less than you invest. ETF costs also apply.
This communication is provided for general information only and should not be construed as advice. If in doubt you may wish to consult a professional adviser for guidance.
Tax treatment depends on personal circumstances and is subject to change, and past performance is not a reliable indicator of future returns.