When markets are volatile, investors sometimes make rash decisions based on their emotions. Naturally, you want to do everything you can to protect your money and reduce your losses.
But what if there was a simple strategy you could employ to reduce the impact of market swings? Pound cost averaging is a common method to counteract this.
- Pound cost averaging explained
- How does it compare to Lum Sum investing
- Benefits of pound cost averaging
- Disadvantages
- How to start investing regularly
Pound cost averaging explained
Pound cost averaging is simply the strategy of regularly investing small amounts of money over time. At Wealthify, we like to call it 'drip-feeding' your account.
In fact, if you have a Direct Debit set up to pay into your investment account each month, you're already doing it!
How pound cost averaging works
If you invested £200 every month for a year (£2,400 in total), here’s an example of how the pound cost averaging could play out:
In the first month, the initial £200 can afford 78.1 units to be purchased at £2.56 each. In month two, the cost per unit is a little cheaper, meaning more units could be purchased with that £200 (94.3 units at £2.12).
However, in month 10, the unit cost is more expensive at £3.24. This means the monthly £200 deposit would only allow 61.7 units to be purchased at that time.
By the end of month 12, £2,400 has been invested. In this example, using the pound cost averaging method has meant 1,108.543 units have been purchased with that money over the year.
Whereas if the money had been invested as a lump sum in the first month, the cost per unit would have been £2.56 each (given how the markets were performing):
- As a lump sum: 937.5 units purchased for £2,400.
- With pound cost averaging: 1,108.543 units were purchased for £2,4000.
Pound cost averaging vs lump sum
So, how do the two compare? Here’s a quick overview of the two strategies:
Investing a lump sum
The main benefit of investing a lump sum is the time spent in the market.
While there’s no guarantee your money would perform better during this time, many people follow the investment strategy that the more time you spend invested, the more likely your money would be to financially ride out any dips in the market.
Even if your lump sum isn’t able to purchase as many units as the pound cost averaging method, the truth is there’s no way to know until time passes. You could invest your lump sum during a market dip, when the unit value is very low and make lots of gains as the markets rise again.
That may feel too risky for some people though, which is why they might prefer incremental deposits instead.
Pound cost averaging
As a basic principle, pound cost averaging is similar to the ‘little and often’ rule, where you pay smaller amounts on a regular basis to reach your saving/investing goal.
It comes in handy for those who are feeling a bit nervous about getting into investing. Likewise, for people who aren’t feeling confident enough to run their own DIY portfolio, or just don’t have enough spare time to monitor the market highs and lows.
By setting up a regular payment (like a Direct Debit), you can autopilot your investing strategy.
This also applies when using a platform like Wealthify, where you have an expert Investing Team doing the heavy lifting for you.
Benefits of pound cost averaging
There are three main benefits to pound cost averaging:
1. Smoothing over market volatility
The nature of investing means there will always be highs and lows in market performance. And by choosing the pound cost averaging route, you can try to ignore the temptation to react to the negative downturns.
The theory behind this is that you remove any emotionally driven reactions to financial markets. In fact, you're actively ignoring the downturns (but that also means you're ignoring the markets rising).
Remember though, with investing, your capital is at risk, and you could get back less than you put in no matter which strategy you go for.
2. Mitigating stress
If you’re new to investing and feel a tad nervous about depositing a big lump sum to get started, setting up a regular Direct Debit of a lower amount is a good way to ease yourself into it.
By contributing regularly and automatically, it shouldn't feel like you're taking so much of a risk when you invest, as you're not basing when you invest on what’s happening with the markets.
3. Creating good habits
With the pound cost averaging strategy, sometimes you'll purchase investments at a low price, and sometimes you'll buy high.
But by buying investments in this way, not only is there a better chance of ironing out some of the bumps in the market, but you could be forming a good money-saving habit, too.
Disadvantages of pound cost averaging
On the other side of the coin, there are some elements of pound cost averaging to be aware of:
- The potential for slow growth.
- More recent investments won’t have time to grow.
- There’s the possibility of making more money by investing a lump sum.
Start regularly investing today
Ultimately, it’s your decision whether pound cost averaging is right for you, but using the above pros and cons could help you decide.
If you’ve reached a stage where you’re comfortable with taking the step into investing, you can start today with a range of products that can be managed on your behalf. Simply setting up a Direct Debit will get you started.
With Wealthify, you could have:
- A Stocks and Shares ISA for investing up to £20,000 a year in a tax-free way;
- A Junior ISA for investing up to £9,000 on behalf of your child every tax year until they turn 18.;
- And a Personal Pension, that could offer you a 25% tax-free top-up for everything you contribute (annual limits apply).
Ready to put your investment strategy into action? Visit our Create a Plan page to explore how you can start investing on your terms.
Your tax treatment will depend on your individual circumstances, and it may be subject to change in the future.
Please remember the value of your investments can go down as well as up, and you could get back less than invested.
Wealthify does not provide financial advice. Please seek financial advice if you are unsure about investing.
References:
1. https://global.morningstar.com/en-gb/personal-finance/drip-feeding-vs-lump-sum-investing
