Many of my preceding articles extol the benefits of stock market investing over the longer term. One common fear, even among experienced investors, is that markets may fall very soon after making an investment. While experienced investors understand that markets fall as well as rise, no one wants to see their money fall in value – let alone soon after investing it.

In this month’s article, I shall explain an alternative to making a one-off investment of capital, especially pertinent as many stock markets around the world are at or around an all-time high. Some investors favour a pound-cost averaging (PCA) approach to deploying their investment capital. Unlike lump-sum investing, in which the full amount of available capital is invested up front, PCA spreads out investment contributions using instalments over time. The appeal of PCA is the perception that it helps investors ‘diversify’ the cost of entry into the market, buying shares at prices that fall somewhere between the highs and lows of a fluctuating market. So, what are the implications of PCA for investors aiming to generate long-term wealth?

Entry Level

Let’s take the hypothetical example of an investor with £12,000 in cash earmarked for investment in stocks. Instead of buying £12,000 in stocks today, an investor going the PCA route buys £1,000 worth of stocks each month for the next 12 months. If the market increases in value each month during this period, the PCA investor will pay a higher price on average than if investing all up front. If the market decreases steadily over the next 12 months, the opposite will be true.

While investors may focus on the prices paid for these instalments, it’s important to remember that, unlike with the lump-sum approach, a meaningful portion of the investor’s capital is remaining in cash rather than gaining exposure to the stock market. During the process of capital deployment in this hypothetical example, half the investable assets on average are forfeiting the higher expected returns of the stock market. For investors with the goal of accumulating wealth, this is potentially a big opportunity cost.

Despite the drawbacks of pound-cost averaging, some may be hesitant to put down all their investable money at once. If markets have recently hit all-time highs, investors may wonder whether they have already missed the best returns and so ought to wait for a drop before getting into the market. Conversely, if stocks have just fallen and news reports suggest more declines could be on the way, some investors might take that as a signal that waiting to buy is the wiser course. Driving the similar reactions to these very different scenarios is one fear: what if I make an investment today and the price goes down tomorrow?

October 2020