Pound Cost Averaging or Ravaging?

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Fairly recently I caused a bit of a stir on the Tweets when I suggested that People who have regular payment plans into Funds (normally Unit Trusts – see my ‘Funds’ page for definitions of what the different types of Funds actually are), might be wise to suspend the automatic payments prior to the Coronavirus problems when it is highly likely that we could see Stockmarkets really struggling.
 
I got a lot of flak for this and it is very understandable why because there are maybe some advantages of such drip-feeding over time; but for me personally, I wouldn’t do this at all. But then I am perhaps a different type of Investor to many others and there is an element of ‘Horses for Courses’.

​As a key principle I am highly skeptical of many arrangements that the Financial Services Industry ‘kindly’ targets at Retail Investors and there are many reasons to take the view that they are often more to the benefit of the Fund Management Company than to the Individual who partakes in them - and I will most likely type more about this as I develop this blog.
 
Following the minor furore that I set off, I had some conversations about this and without doubt there are good reasons to do this sort of thing but there are also some bad ones. Probably the best reason to do such a drip-feed on a Monthly basis or something is because it takes away the responsibility of managing the Money from the Private Investor and because it therefore adds to overall Diversification by, in effect, spreading the management skills between the Private Investor and a mostly unconnected Fund Management Team who may turn out to do a better or worse job of it.
 
I am assuming in the above paragraph that the Private Investor we are talking about is in this case somebody who runs a Portfolio themselves where they might buy just individual Shares maybe, or they might just buy Funds or they might have more sophisticated things like Bonds and Property or whatever. I am making a clear distinction here between the ‘interested and enthusiastic’ Private Investor and a quite different type who knows little about the Stockmarket or Money Management in general and who takes little interest in it and who does not have the time or the inclination to do it.
 
In the example of the ‘uninvolved’ Private Investor I would suggest that Monthly Drip-Feeding of Money into a mixed and diversified Portfolio of Funds is a good thing to do but it is important to understand what I have just written. What I am not saying is that it is a good idea to pay a Monthly Sum into a Stockmarket based Fund like a Unit Trust ON ITS OWN. If you do this you will be buying lots of Shares at Market Peaks and you are obviously going to be losing Money on such buys and it clearly doesn’t make much sense when there are better ways to do the whole process.
 
The way I would suggest that someone does such Investment would be to have a Diversified Portfolio of various Assets but mainly with some Stockmarket stuff and some Bond Funds – this last bit is critical because when you are drip-feeding your Money in you won’t just be buying expensive and over-priced Stocks but you will also be buying Cheap and under-priced Bonds. If you look on my ‘Funds’ page I have written a fair bit about this and there is an example of a Diversified Funds Portfolio of Unit Trusts that I help a friend manage.
 
Sorry this blog is going to ramble around the subject a bit but I know how you love my unstructured and natural writing style !! One of the big problems I have with the idea of Money Drip-Feed just into an Equity Unit Trust is that in more ‘normal’ times there perhaps is a bit of sense to it because the Peaks won’t necessarily be that different to the ‘Troughs’ in distance terms (the number of Points on an Index or Percentage difference etc.), but what concerns me is when you get proper full-on Bubbles.
 
I wonder how many people were still paying their Monthly Cash into crazily over-priced Technology Funds back in the period from probably 1997 to 2001 or so – when you think about it, that was 4 years where you were not getting any benefit from ‘Pound Cost Averaging’ (that really was ‘Ravaging’) and I am very sure that many people were fooled by the Marketing of the Tech Funds companies and will have signed up to such Monthly schemes. I know the Marketing was attractive because I fell for it like the total novice I was, but luckily I didn’t buy too much and my input was in the form of a lump rather than continually buying very over-priced Stock for month after month for perhaps years.
 
So why is the Fund Management Industry so keen on signing you up to Monthly Payment schemes? On the face of it you can see why people are taken in – the argument of ‘Pound Cost Averaging’ is very sound (when used the right way !!) and the commitment & discipline forced upon you by regular savings is obviously good. But what Retail Punters miss is that the benefits for Fund Management Groups are significant.
 
Firstly, they love the fact they have tied you in to providing them with dollops of fresh new Cash every month. This gives them more ‘Funds under Management’ (FUM) upon which they take a ‘small’ percentage. This all seems reasonable because they might take as little as 1% a year from you (in practice many have higher fees than this and an upfront fee as well !!) but think about what it does to their Profits. If a Company is managing, say, £100m and it charges a 1% Fee, then they get £1,000,000 in total.
 
Now imagine they get lots more Retail Punters to sign up to Monthly Schemes and of course they will also be taking lump-sum Cash Investments as well. Let’s say the FUM goes up to £300m and therefore the Company gets £3,000,000 in Fees. But an important point to realise is that the actual Costs of managing the Fund have barely changed – a Fund that can run with a small group of Managers and Analysts etc. doesn’t need to add many as the FUM rises – if anything, the biggest rising costs will be the Marketing Department to drag in unsuspecting Punters !!
 
The other big attraction for the Fund Management Company is that they lock you in. They know how lazy all us Humans are and how we have so much going on in our lives with Work and Family and all that stuff and how once they have ‘captured’ us, they will probably have us for many, many years. It is a superb business strategy and you have to admire it really.
 
If you must do a Monthly Drip-feed into a Stock focused Fund then doing so into Equity Income Funds with a Dividend focus is probably the best way to do it. Paying in such a way into just a Growth Fund could work out very badly (how many people are doing this into Scottish Mortgage at the moment I wonder?).
 
Quite frankly, if I was going down this path I would be using Investment Trusts and maybe ETFs rather than Unit Trusts and Trackers and rather than a Monthly drip-feed into the Funds I would be paying a Monthly amount into a separate Bank Account and then allocating the Money across a Portfolio of Collective Assets as I decide. This would help with balance across the Assets and also mean that when Markets are obviously extremely Risky (like at the time of typing this as the Coronavirus problems are probably just starting) I could just let the Cash build up to deploy when things are safer and it would mean I could be greedy around Market Bottoms when Pound Cost Averaging can really help. In other words I would be buying chunks around what I think is getting near or just after the Bottom. Don’t worry, I intend to write more blogs about this Bottom thing in coming weeks.
 
The disadvantage of such an approach is that you need discipline to do it well.
 
The way Pound Cost Averaging is done if you just blindly pay into a Fund every month is completely the wrong way you should be buying and selling. You should be Selling in chunks around Market Peaks and you should be buying in chunks around Market troughs. Just buying across the whole cycle is hugely missing the point.
 
“But you can’t time the Markets !!” I hear you screaming. I don’t agree with this at all and if you truly believe this then you should be studying Technical Analysis to realise how incorrect this glib statement is. This is something that is trotted out constantly by the Fund Management Industry and supported with highly dubious Charts and Performance over selected Timeframes and it is really dangerous thinking.
 
If you are new to Investing and know pretty much nothing then there might be some sense to it but if you have been involved in the Markets for a few years then it should be pretty obvious when Markets are toppy in terms of Valuations (I have been screaming about this for months !!) and if you have access to a basic Charting package (loads are free on the Interweb) and can draw a few lines then you should be able to see a Peak very easily. Read my Weekend blogs and they will tell you anyway.
 
And this gets back to another angle on this whole subject. If you are a fairly active Investor with several years of experience, then even if you do decide to have a Monthly Drip-feed Scheme into a Stock focused Unit Trust, then you should have enough understanding to be able to cease your Payments at seriously risky times and to be able to turn it on again when things are safer and probably the Markets are a lot lower.
 
Something else worth mentioning is that there are some Unit Trusts that cannot be bought in the form of an Investment Trust. For such Funds then it makes sense to buy them if they have an outstanding performance like the Mark Slater one or that Buffettology jobbie, but again a Drip-feed might not be wise. If you are an active Investor (and if you are reading this then you most likely are or at least you are starting your journey in that direction) then I see no reason why you wouldn’t just save money up every month and buy into the Fund at what you think are the best times. It cannot be that hard.
 
I very much like the idea of a Portfolio or set of Portfolios that you manage yourself and then having something that is a ‘Core’ holding that could be a Portfolio of Funds or something. I myself have a beastie called the ‘Prudential ‘With Profits’ Bond’ which you can see mentioned on the ‘Funds’ page and this is a sweet thing because over 20+ years it has been extremely steady and it has returned much better than Cash but is clearly very low risk. It is a mix of Asset Classes and has an advantage in that it locks you in for the first 5 years - which as a Newbie would be a good time to have some discipline forced on you !!
 
Before I tail this off, I must just mention a similar issue with Dividend Reinvestment Schemes (DRIP). I know I have written about this before and it would have been in relation to how I mismanage my Income Portfolio, but I just find such schemes not really how I wish to do things and the only real benefit I can see is the simple ease of letting them do the work for you.
 
The essence of a DRIP scheme is that you instruct a Company that pays you a Dividend to buy more Shares in the Market rather than giving you the Cash Payment. That sounds fine until you think about what it means and as with the Monthly Investments on Funds, you need to wonder who actually benefits from such arrangements. The problem is that like with the Funds, when Markets are toppy and Prices are high, you are still automatically buying Shares and often it is obvious to almost anyone that Markets are wobbly – that is certainly the case as I type this on 5th March 2020 when we are just getting into the Coronavirus issues.
 
The way I prefer to do things is to let the Cash from various Companies within my Income Portfolio (and for that matter, I do the same in my other Accounts) build up and once I am happy there is enough in there to justify buying either a new Position entirely, or topping up on something I already hold, I will then make the decision myself and buy with the Cash. This has the benefits of meaning I can buy something where the Price seems low and more attractive but it also means I can ensure some balance in terms of Position Sizes across my Portfolio.
 
If you are letting the Company buy more Shares for you, then you might end up with some Holdings becoming much bigger than the others and this introduces Risk both in terms of a high Share Price and less diversification.
 
Because of the very inactive way I do things, I must say I do like to actually do a Trade now and again and doing things this way means I get an opportunity to have the ‘fun’ of investigating a few things and making decisions about how to manage my Portfolio. The other sweet aspect of this method is that you see dollops of Cash slowly building up over time and that is a lovely feeling !!
 
In terms of who benefits from these DRIP schemes, it strikes me that many Management, particularly in large Companies, are paid their Bonus partly related to the level of the Share Price – clearly doing Share Buybacks and DRIP schemes helps them achieve this aim !!!
 
Anyway, hopefully that has cleared up my thinking behind those Tweets I sent out and made Readers weigh up how they do things. It might be that you decide to tweak your approach after seeing this and whatever you do make sure you think things through carefully.
 
Cheers, WD.