The advantage of regular saving
There can be strong benefits gained by saving into stock markets on a regular basis. This can be significant when ‘Pound Cost Averaging’ is taken into account. This term means that on average, less is paid for purchases over time than the average price of the shares over that period.
The most important aspect of saving is time, as stock markets produce higher gains than lower risk assets, such as cash, and so over time these gains are multiplied dramatically.
The other important effect is compounding, or the ‘gains on the gains’. If the stock market provides similar long term returns as it has historically (c. 6% after allowing for inflation), investors with £1,000 will achieve a tripling of their original capital to more than £3,000 over 20 years. If the return is not accumulated, then a gain of £1,200 is received in addition to the original capital.
Pound Cost Averaging
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.
Saving over time – start as soon as possible.
The advantage of regular saving can be highlighted with a brief example:
A parent saves £500 each year from the birth of their child to his/her 9th birthday (£5,000) and then invests no more. This is invested in the stock market and achieves an average return of 7% each year. When their child is 65, that fund will be worth £305,000 and could provide an income of £12,000 annually for the rest of their life at 4% p.a (leaving the capital intact).
Alternatively, they continue the investment and pay into the fund until their child is 19 (£10,000). When their child is 65 the fund would be worth £460,000.
If another child had no savings , but wanted to replicate the first child’s fund at age 65 but only started saving at age 25, the amount that would be needed to be saved EACH YEAR until they were 65 would be £1,500 p.a.(£61,500) for scenario 1 and £2,150 p.a. (£88,150) for scenario 2