Pound cost averaging is where an individual invests relatively small amounts in a very regular, staggered way. The alternative would be to pay in in irregular lump sums.
Pound-cost averaging only works for regular premium contracts. The yield obtained from the policy depends mainly on the bid prices of units on the day the policy is cashed in.
If unit prices are low at times during the term of the policy this can work to the saver’s benefit. When prices are low, the premiums buy more units than they would if prices were higher.
The saver will receive a better return if prices are low for a long period and then rise just before the policy is encashed, than if the prices rise to the same eventual height but at a consistent gentle growth rate.
This is because units will have been bought on average at a lower cost in the years of low prices. This factor is known as pound-cost averaging.
Pound cost averaging as a concept is not just relevant for life assurance policies but also other types of regular premium investment.
Question - Use Your Note Taker To Jot Down Ideas / Calculations
1. Four clients hold different investment products. Which one of them would most likely benefit from
pound cost averaging?
a) Catherine, who is paying £300 a month into a 10-year traditional with profits
endowment policy.
b) Peter, who is paying £300 a month into a unit trust, invested in a specialist growth fund.
c) Paul, who has paid £30,000 into an investment trust that is traded at a substantial
discount.
d) Susan, who is paying £300 a month into a cash based ISA.
B)
Pound cost averaging is applicable to unit linked investments and only when a regular premium is
paid – b is the only investment that meets these criteria.
- Further study text reading: Pages 255-257