Why drip feeding won’t make you rich

Pound cost averaging (PCA) the theory that the best bet for a retail investor is to drip feed a regular amount into the stock-market sounds appealing on two counts. First, it's easy it just involves setting up a direct debit to stick say £500 a month into a FTSE 100 tracker, or whatever fund you prefer. Second, by buying each month rather than putting in a lump sum, fans of PCA claim you can smooth out volatility and minimise the impact of investing on a down day. Fund managers in particular like to claim that it's not timing the market that matters it's time in the market. Are they right?

How the numbers stack up

At first sight, the maths behind PCA can seem compelling. Suppose you have £2,000 to invest over four months and put £500 a month into shares. Month one you buy 25 shares at £20 each. The next month the price is £10, so you buy 50 shares. In month three you buy 100 shares for £5 and in month four you pay £20 each for another 25. In total you've bought 200 shares for an average cost of £10 (£2,000/200). That's less than the average monthly price per share on the day of purchase £13.75 or (£20+£10+£5+£20)/4. With a closing price of £20 in month four, your holding is worth 200 x £20, or £4,000 so you're quids in.

But this example is misleading. If, for example, you took four months of rising prices instead of the examples given, PCA compares poorly with simply investing a lump sum in month one. And, in any case, why invest in a falling market at all if that's what you expect? Better to sit on the sidelines and wait for better times.

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PCA fans also tend to assume the lump-sum investor is an idiot who always piles in at the top of the market in the above example, investing your full £2,000 in month one, for example, would see you barely break even after four months (after dealing costs and stamp duty). But such an investor, faced with a fallling market, could adopt a cannier approach.

Rather than invest in month one, they could wait, then invest say £1,000 to buy 200 shares for £5 each in month three and keep £1,000 back in case prices fall further. They would then have £4,000-worth of shares by the end of month four (the 200 bought for £5 each would be worth £20 each at that point) plus another £1,000 in cash. That beats the PCA approach by 25% (£5,000/£4,000). Also, a PCA investor who pays a fixed commission to trade suffers four sets of dealing costs rather than the single one suffered by the lump-sum investor.

Timing is everything

These flaws are backed by research that shows that the PCA approach struggles to outperform over long periods. As Tudor Davies points out on Motley Fool, investment consultant Michael Edesess has shown that, over 83 years, investing a lump sum actually beat investing via PCA by more than 3% a year whether you look at one, three or five-year rolling periods. Sure, PCA's returns come with less risk (the 'standard deviation' a measure of the distribution of returns around the average is lower). But if low risk is your stated objective, you should probably forget stocks altogether and open a bank account or buy government bonds.

An alternative: modified PCA

Critics of 'plain vanilla' PCA have tried to devise alternatives which modify the original theory so that a regular investor buys more shares when they are cheap and fewer when they are pricey. For example, an investor with £2,000 to invest could aim to grow the value of a portfolio by say £500 a month. So, having bought 25 shares in month one at a price of £20, you then invest based on what the portfolio is worth a month later. The answer is just £250 (£10 x 25). Since your target by the end of month two is to have £1,000 invested, you need to buy 75 shares at the new price of £10. By month three, with the share price at £5, your shares are worth £500 (100 shares x £5). So you spend the £750 that's left on 150 new shares (since 150 x £5 = £750). By year four, with the price at £20 per share, you have a portfolio value of £5,000 (250 shares x £20 per share).

Better still: be a value investor

Modified PCA produces better results but is pretty fiddly in practice you can't set up a direct debit for the same monthly amount, for example. A better approach is to be "greedy when others are fearful" and buy as many shares as you can when they are cheap. Classic value investing first promoted widely by investor Ben Graham uses ratios such as price/book and price/earnings (p/e) to identify bargains. Right now, for example, Citi analyst Jonathan Stubbs reckons that some defensive sectors such as pharmaceuticals are "cheap, cheap, cheap" with p/e ratios are as low as they have been "for two decades". We like GlaxoSmithKline (LSE: GSK) on a p/e of 8.8 and a forward yield of 6.2% or AstraZeneca (LSE: AZN) on a p/e of 7.1 times and a forward yield of 5.2%.