Benefiting from volatility

Pound cost averaging is a fancy term which describes how you can build up a capital sum by investing a fixed amount of money in a particular investment vehicle (shares or fund) on a regular, usually monthly, basis. It is most often used with equity-based investments rather than bonds or fixed income assets that tend to be less volatile.

The key point about pound cost averaging is that you invest small amounts on a regular basis. This means that when prices are high your monthly contribution may buy fewer shares or fund units but that when prices are low your investment buys more shares or fund units. This continuous drip-feed method of purchasing your investment means that the average purchase price paid over any given period is going to be lower than the arithmetical average of the market price. It also instills a useful discipline in the investor, creating the saving habit. Pound cost averaging takes the worry out of investment decision-making - you do not need to panic when the price falls because you will merely be buying more of your chosen investment and because you are committing funds on a regular basis you need not worry about investing all your savings at the top of the market either.

While pound cost averaging can reduce your risk, it is a strategy that does benefit from volatile markets. The more the market swings the greater the benefit to somebody using pound cost averaging. For example, if the market swings down every other month then on each downturn you would buy more shares or units, which would be worth yet more on each upturn. In a bear market, pound cost averaging allows you to build up an investment poised to benefit from a recovery without having to worry about trying to work out when the bottom of the market will occur. However, the strategy will mean you would lose out on the best of the growth in a rising market, although this is a small price to pay for the added security that pound cost averaging brings to investment decision-making.

The diagram above shows how the share price of a theoretical investment (represented by the dots) can fluctuate over time. As can be seen from the bars, an investment of £100 per month buys a lower number of shares when the share price rises but a higher number of shares when the share price falls.