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Nearly every financial adviser has been brought up on the theory that making an investment in instalments can produce benefits compared with investing a lump sum. Unfortunately, one cannot know in advance whether it is better to invest a lump sum immediately or spread it over a period.

In this series of articles, I will examine various scenarios and comment on the effectiveness of pound-cost averaging. I will bring into question whether pound-cost averaging works always, sometimes or never. Indeed, does it have any real long-term relevance at all?

In my first scenario, I will assume that the unit price at the end of a year is the same as at the start of the year. There are three directions that the price could have taken during the intermediate months:

•The price stayed unchanged throughout the period.

•The price went up in mid term and then went back down.

•The price went down in mid term and then went back up.

Let us assume the price at the start of the year was £1 and our saver invested £100 a month.

In the situation where the price remained unchanged during the period, at the end of the year the investor would have bought 1,200 units (£1 x 100 x 12) to accumulate a fund value of £1,200 (£1 x 1,200). The number of units bought is the same as if a lump sum of £1,200 had been invested at the beginning of the year and the value is the same as well.

Table 1 examines the two other possibilities. The average price of all units bought where the price went down and then back up is £0.86 (£1,200 divided by 1,391.28. Where the price went up but then back down, the average price is £1.12 (£1,200 divided by 1,078.52).

It can be seen that the difference as a result of investing monthly rather than a lump sum at the beginning of the year is a gain of £191.28 (15.94 per cent) or a loss of £121.48 (-10.12 per cent), depending on which way the price goes during the period in question.

This shows that pound-cost averaging might not always work in favour of the regular investor. The result depends on price trends over the period. Arguably, the regular-premium investor is just as likely to lose money as to gain money.

But what if the price is lower at the end of the year than at the beginning? Again, there are three directions that the price could have taken during the intermediate months:

•The price went up initially but then went down, wiping out all the initial gains.

•The price went down, up and then down again.

•The price went down in a uniform manner.

Table 2 examines the three possibilities. The average price of units purchased where the price went up and then down is £0.95. Where the price went up, down and up again, the average price is £0.80. Where the price just kept going down, the average cost is £0.69.

These three situations demonstrate the difference as a result of investing monthly rather than investing a lump sum at the beginning of the year. Pound-cost averaging clearly cannot make a profit for the investor in the event of a significant downward price trend – at least not in the short term. But the loss is less than if the investment of £1,200 had been made at the start of the year. The 1,200 units then purchased would have been worth only £600 at the end of 12 months.

Finally, let us look at a year in which the price is higher at the end of the year than at the beginning. Once again, there are three directions that the price could have taken during the intermediate months:

•The price went down and then went up, more than making up for the fall.

•The price went up, down and then up again, finishing at a higher level.

•The price rose steadily.

It can be seen from Table 3 that the average price of units purchased where the price went down and then up again was almost exactly £1. Where the price went up, down and up again, the average price was £1.21. Where the price just kept going up, the average cost per unit was £1.25.

In each situation, the investor has made a profit but this needs to be compared with the profit arising if the investment of £1,200 had been made at the beginning of the year. The 1,200 units then purchased would have been worth £1,800 at the end of 12 months.

These examples are indicative of the gains or losses than can occur over a 12-month period in respect of spreading an investment of £1,200 over that time rather than investing it all at the beginning of the year. But what happens when we look at this principle over a number of years rather than over a number of months?My next article will bring this question into focus.

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