One of the biggest fears of investors is a large fall in the value of their portfolio shortly after investing. The technical word for this is asymmetric risk.

Asymmetrical risk-reward is the essence of investing in stocks and is also essential for those who want to beat the market.

Asymmetrical Risk Reward

An asymmetrical risk-reward situation can be both positive and negative. A positive one is where you can only lose an amount that is smaller than the potential reward.

A negative risk-reward situation is one where you can lose more than what the potential positive reward is.

 

A smart way to reduce the asymmetric risk is by drip-feeding your investment using a technique known as Pound Cost Averaging rather than investing all of your money upfront.

The example below shows the Pound Cost Average method for two different investors over a volatile period.

Month Price Investor A Investor B
January £2.00 £1,000 £12,000
February £1.91 £1,000
March £1.74 £1,000
April £1.70 £1,000
May £1.65 £1,000
June £1.57 £1,000
July £1.52 £1,000
August £1.57 £1,000
September £1.61 £1,000
October £1.65 £1,000
November £1.74 £1,000
December £1.83 £1,000

 

Total Unit Purchased 7,077 6,000
Average Price Paid £1.71 £2.00
Final Value £12,923 £10,956

*Past performance is not a guide to future performance.

 

Investor A invests £1,000 a month over the year whereas Investor B invests £12,000 in January.  Across the year, the market falls and rises with the unit price following the same trend.

By December, Investor A has been able to take advantage of falling prices and has purchased over 1,000 more units and paid a lower average price than Investor B.  This leaves Investor A with almost £2,000 more over the one-year time frame.

Of course, if prices have kept rising instead of falling then you would have been worse off by using pound cost averaging because the average price paid could have been higher than if you had invested the full amount at the outset.

 

The upside of pound cost averaging is obvious when markets fall because you are buying at lower average prices.  However, on average share prices rise 6 months out of every 10 months which means that on average you will be worse off by using pound cost averaging.  However, for risk-averse investors, especially those investing a large lump sum, the peace of mind afforded by pound cost averaging may be considered worth it on balance.

So if you are interested in investing a large lump sum and you are apprehensive about a potentially large fall in stock markets why not consider pound cost averaging?  You know it makes sense*.

 

*The value of your investment can fall as well as rise and is not guaranteed. The contents of this blog are for information purposes only and do not constitute individual advice. All information contained in this article is based on our current understanding of taxation, legislation and regulations in the current tax year. Any levels and bases of and reliefs from taxation are subject to change. Tax treatment is based on individual circumstances and may be subject to change in the future.