Pond Cost Averaging

Pound Cost Averaging reduces your risk to a share’s short-term price movement

As a dividend income investor we intend to buy shares when they are historically undervalued. In comparison, the pound cost averaging investor buys equal pound amounts of the same shares at regular intervals – monthly, quarterly or annually – whether the shares are undervalued or not.

Please note the italics in that last sentence. Pound-cost averaging IS NOT buying a fixed number of shares on a regular basis. In fact, it is quite the opposite.

Here’s why

Let’s say you’ve decided to invest £10,000 in ABC Plc. However, you are unsure whether the current share price offers “good value”, or, indeed whether the shares are historically undervalued.

Instead, rather than deploying the entire amount all at once, you decide to purchase £1,000 of ABC shares on the first day of each of the next 10 months.
Or you can decide to set it for the last day of the month, or the fifth day, or whatever. It doesn’t really matter.

What happens is that by using a pound cost averaging strategy you average the higher share prices with the lower prices.

What is the logic behind pound cost averaging?

No company’s share price remains static for any period of time. So, when a company’s share price is higher, your £1,000 will buy fewer shares, but when the share price is lower, your £1,000 will buy more shares.

It decreases risk

Buying equal pound amounts over time allows you to reduce your risk to a share’s short-term price movement. It automatically encourages you to buy more when prices are lower and less when prices are higher.

Buying on auto-pilot

It also removes much of the emotion from the whole investing process. You have already committed to buying this particular company’s share at regular intervals, regardless of market conditions.

And because pound cost averaging can be done automatically, it doesn’t require you more than a few minutes of your time to set it up.

It works particularly well in downturns

You may ask yourself does pound cost averaging work in any situation, even in periods like the major downturn during 2008/09?

Critics will argue that pound cost averaging does not allow you to buy shares at the lowest points or get the best price possible. They are quite right — it doesn’t.

However, as this example shows it worked quite well.

Pound cost averaging when a share is undervalued

When a share is truly undervalued, pound cost averaging works very well, indeed. A regular purchase of a share which is historically undervalued builds a much larger overall shareholding.

Pound cost averaging works especially well in a bear market, when share prices are falling rapidly. As before, the same amount of pounds will purchase more shares, reducing the average price per share.

However, when the bear market eventually ends, and the share price starts rising again, the shares may not be any longer historically undervalued. At that stage, pound cost averaging should be stopped and reversed when the share price nears an overvalued area.

The extra shares purchased of high quality companies at
undervalued share prices using a pound cost averaging
strategy will cause returns to rocket when prices recover!

And it’s exactly these types of high quality companies with increasing dividend payments that I would be considering for the Dividend Income Portfolio.

What next?

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