What is Pound Cost Averaging & How Does Compounding Work?
Compounding and Pound Cost Averaging is one of those things I talk about a lot. In fact most people in the investment world talk about it. But what exactly is pound cost averaging?
Compounding, according to Einstein, is the 8th wonder of the world, but again, what exactly is compounding?
I cover both topics in my book, but I’ll try again – specifically for one person who keeps on asking me about it – as if I’m explaining it to an uninterested puppy.
Pound Cost Averaging
It’s an awkward sounding phrase, but what it means is;
“Spending the same amount of money but buying a varying quantity.”
Let’s use an example. Let’s say you and your neighbour are planning on building a skyscraper out of wood one day, so you both need to stock pile wood.
Each day you go to the wood shop and buy wood, which is currently £1 per kg.
You go and buy 100kg of wood each day, your neighbour goes and spends £100 each day.
Some days wood is cheap, only £0.50 per kg. Other days it’s more expensive, £1.50 per kg.
So it ends up looking something like this;
In the same 10 days, you both spend the same amount of money.
The average price of wood across the 10 days was £1 per kilogram. But by spending the same amount each day, instead of buying the same quantity each day, your neighbour has ended up with 20% more wood than you.
His skyscraper is going to be taller than yours, which means they are cooler than you. And you’ll never get a date.
How Does Pound Cost Averaging Work?
It works on the principle that when things are cheap, you buy more. When things are expensive, you buy less.
So in our above example, when there was a 50% sale on, instead of saving money and only spending half the amount, your neighbour kept his spend the same but ended up buying twice as much.
Equally when prices when up 50%, instead of shelling out more money, they just bought a bit less so they remained on budget.
When it comes to investing, ^ is a ridiculously easy way to make sure you aren’t over paying for something. If it gets really expensive, then you buy less of it. If it gets cheap, you buy more of it.
The way compounding works is by leaving something to grow, and then when it grows, leaving the extra to grow as well.
Another example, and one that is dear to my heart. TREES!
Imagine you own a forest that has 100 trees in it. Every year those trees drop their acorns and produce 10 more trees.
Because you’re trying to supply wood to those two nutters who want to build a skyscraper out of wood, you cut down 10 trees each year, so you end up with your original 100 trees again.
This goes on forever, and you have a nice way of making 10 trees a year.
Compounding leaves (get it?) those 10 trees to create another tree next year.
Let’s check it out in a chart – cos charts are great.
How Does Compounding Work?
By taking the growth each year – or the interest if it’s a financial instrument – and not allowing it to grow, the non-compounder has ended up after 10 years with the same amount of trees, but has taken 100 trees themselves.
The compounder, by leaving the new trees in their forest, and letting those trees produce new trees as well, has ended up with 259 trees.
That’s an extra 59 trees that they can do what they want with now.
When it comes to finances, by leaving the money to grow you are allowing the profits to remain and earn more profits for you.
If you keep taking the profits away, then you are limiting how much you can grow your pot.
Fine. I’ll give you that. It does take a while longer for compounding to really start being impressive. But take this for example…
10 years growth at 10% each year starting with £100 = £259 or 159% growth
20 years growth at 10% each year starting with £100 = £673 or 573% growth
30 years growth at 10% each year starting with £100 = £1,745 or 1,645% growth
What everyone should take away from this is the earlier you start, the better! So crack on with it.
I’ve tried a bunch of different ways now to explain this, if you still don’t get it, I don’t know what to say.
Just trust me and do as I say? Maybe that’ll work.
Pound Cost Averaging and Compounding are some of the easiest and yet most powerful ways to grow your investments over the long term.
I talk about these in more detail, and show you how to practically apply them to your investments – as well as another one that is the cherry on top of these sundaes – in my Money Masterclass.
If you’re ready to invest and want to do it in the most sensible way, then this is the best way I can help you get started. Probably check it out.