What’s pound cost averaging and how does it work?
When investing, there are numerous questions to answer, from how much risk you want to take to how much you’ll invest. Among these is how you’ll build up your portfolio. There are essentially two options to consider: deposit a single lump sum or drip-feed investments on a regular basis, known as pound cost averaging.
Pound cost averaging means you spread out when you purchase stocks and shares. It aims to help smooth out market volatility by purchasing at different points. This helps to reduce the risk of investing all your money at extreme highs but also does the same for extreme lows. Over the long term, it should mean you pay an average price for units.
Pound cost averaging is a common investment strategy, but what are the benefits of doing so and is it the right option for you?
Spread the risk: This is one of the key benefits of pound cost averaging. Investment markets experience volatility, with the costs of stocks and shares changing in line with a huge number of factors. It’s near impossible to consistently predict how prices will change. As you’ll be investing over a period of time, the theory is that you’ll buy at both high and low points, smoothing out market volatility. In contrast, if you invest all at once, you risk seeing your entire portfolio decreasing in value if you purchased at an extreme high.
Reduces market worries: It’s natural to worry about how investments are performing; you want to get the most out of your money. However, with volatility considered, focussing on the short term should be avoided. Making smaller, regular investments can help to give you more confidence in your strategy. With a lump sum deposit, it can be easy to try and second guess market movements to maximise returns through timing. With pound cost averaging, you should have defined points to invest, removing this additional consideration.
Build up a positive money habit: Whether you’re dividing a lump sum into instalments or investing from your income, using pound cost averaging can make investing a habit. You’ll be used to drip-feeding money into investments, a practice that can stick with you long term. Even small deposits can deliver significant returns over the long term, particularly when you consider the effect of compounding. It’s a strategy that can make investing part of your regular financial plan, rather than an area you think about occasionally.
Make use of allowances: If you’re looking for a tax-efficient way to invest, Stocks and Shares ISAs (Individual Savings Accounts) are often a good place to start. Returns generated in a Stocks and Shares ISA aren’t liable for Income Tax. However, you can only deposit up to £20,000 each tax year into ISAs and you can’t carry the allowance forward; if you miss the deadline, the allowance is gone. Pound cost averaging means you can plan monthly deposits with the allowance considered, removing the end of year rush.
Investing a lump sum
If you have a lump sum you want to invest, you may want to do so in one go.
If you’re looking for a hands-off approach to investing with a long time frame, this may be a suitable option; you won’t have to worry about making regular investments. However, there is a risk that you purchase at a high point in the market and experience a loss in value. Should this happen, keeping a long-term outlook in mind can help alleviate your concerns, historically, over the long term, markets have recovered.
In fact, research indicates that whilst a lump sum investment strategy does experience greater volatility, it provides greater returns. Figures from Schroders focussed on the US market demonstrate this:
- A lump sum deposit of $37,200 in 1988 invested in MSCI World Total Return Index would now be worth $350,000 after delivering an annual return of 7.5%
- In contrast, $100 monthly payments starting in 1988 for 31 years would now be worth $123,395 following an annual return of 3.9%
This huge difference can be attributed to the fact that a lump sum deposit means the money has spent a longer time in the markets and benefitted far greater from compound growth than a pound cost averaging strategy. Of course, a strategy of investing a lump sum depends on you having the assets available to do so.
As with all investment decisions, you should also consider how long you plan to invest for. As a general rule of thumb, you should look to invest for a minimum of five years, giving you a greater opportunity to ride out dips in the market.
What’s right for you?
There’s no single solution that’s right for every investor. There are benefits to pound cost averaging, but there are also advantages to investing a lump sum too. Your decision should be based on a range of factors, including your investing time frame, goals and current assets. If you plan to start or expand your current investment portfolio, please get in touch. We’re here to help you understand which strategy is right for you, as well as other key considerations such as diversification, withdrawing an income and potential returns.
Please note: The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.