Recent market turbulence has reminded all investors that their investments can fall as well as rise in value. But, there is one positive to this, especially when you are ‘drip-feeding’ money into a pension (or other investments) by contributing monthly over several years to benefit from ‘pound-cost averaging’.
What is pound-cost averaging?
Every payment you make into your pension buys units that make up each fund you are investing in. If a fund falls in value, the units fall in value making them cheaper to buy. Conversely, as the fund rises in value, so does the unit price with them becoming more expensive to buy.
When a fund falls in value you benefit from “Pound Cost Averaging” when you are investing monthly. You will buy more units in the fund when they are at a lower value.
To see the effect in action, imagine you can invest £100 a month over six months. The unit price is 100, 80, 90, 140, 90, 100 over the six months, with the average unit price being 100 over that period.
In month one; you contribute £100 when the unit price was 100 = 1 unit bought
In month two; you contribute £100 when the unit price was 80 = 1.25 units bought
In month three; you contribute £100 when the unit price was 90 = 1.11 units bought
In month four; you contribute £100 when the unit price was 140 = 0.71 units bought
In month five; you contribute £100 when the unit price was 90 = 1.11 units bought
In month six; you contribute £100 when the unit price was 100 = 1 unit bought
For your £600 you now own 6.18 units worth £618.
If you had bought them all on the first day, you would only have £600, the same if you bought them at an average price.
Are there any drawbacks to contributing monthly rather than making larger ad-hoc contributions?
Now the warnings; if the unit price of the fund you are investing in is gradually increasing over the six months as above, you would buy less units month on month. At the end of the six-month period you will hold less units than you would have done investing a lump sum at the start of the six month period.
The alternative is to make larger ad-hoc contributions where you are essentially trying to ‘time’ the market – hoping you’re investing at a low point from which markets will rise increasing your capital, sadly none of us have that crystal ball which makes it unlikely that you will correctly time the market peaks and troughs.
The importance of having a ‘diversified’ portfolio
You can hold several funds within a pension, each of which can invest in a different asset class; shares, fixed interest, property, cash or other securities such as commodities.
Having a spread of different asset classes within your pension fund ensures it is ‘diversified’ so you don’t have ‘all your eggs in one basket’. Different assets will perform differently at different stages of the economic cycle; for example, share-based funds typically outperform fixed interest funds as the economy grows, but the opposite has been true when recession is looming.
One of the big differences between portfolios designed by advisers and those typically devised by members of the public, is the professionally designed portfolio is usually diversified in such a way to manage this risk.
How do I get professional advice on my pension?
Please contact us at firstname.lastname@example.org or call us on 01223 792 196 to arrange an initial appointment, at no cost to yourself, with one of our Independent Financial Advisers.
About Martin-Redman Partners
We are a team of experienced Financial Advisers who can advise on your personal or business financial arrangements. We have been building trusted relationships with clients for many years by articulating clear and tailored recommendations in areas ranging from investments to retirement planning, to complex estate planning advice.
The information contained is for guidance only and does not constitute financial advice. It is based on our understanding of UK legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change. Accordingly, no responsibility can be assumed by Martin-Redman Partners its officers or employees, for any loss in connection with the content hereof and any such action or inaction.