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What is pound cost averaging, and could it help smooth out market bumps?

Could drip feeding your investment account with regular payments help you ride out market bumps?
Reading time: 4 mins

When markets are volatile, investors typically make rash decisions based on 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?

What is pound cost averaging?

Despite being unnecessarily complicated-sounding jargon (typical investment industry), pound cost averaging is actually very simple. In fact, if you have a Direct Debit set up to pay into your investment account each month, you're already doing it!

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. 

What are the benefits of pound cost averaging?

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.

Overall, 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 is happening with the markets.

In essence, sometimes you'll purchase investments at a low price, and sometimes you'll buy high. By buying investments in this way, you're not only forming a good saving habit, but there's also a better chance that you could iron out some of the bumps in the market.

Depending on your approach to investing, you could automate it and leave it running. For example, you could do this by opening a Wealthify Stocks and Shares ISA, setting up a Direct Debit, and then letting our experts build you an Investment Plan and manage your investments for you.

If you've decided to choose your own investments, this will become a bit trickier, as you may want to be continually monitoring the market for the best buys within your chosen timeframe.

Could drip-feeding really iron out the bumps?

The whole idea behind this tactic is that it could help to offer you some protection in case the market drops shortly after you've invested.

For example, say you invested in a way that tracked the FTSE 100 (the 100 largest companies on the London Stock Exchange) on the 16th of February 2020 - by the 16th of March, this investment would have lost 30% – a considerable drop in just one month.

However, if you'd invested a smaller amount in February and then invested again in March, you could have benefitted from this dip by buying investments at two very different prices. And, for investing the same amount of money, you'd get a lot more shares in return.

In a falling market, this approach could allow you to regularly take advantage of market dips (which are normal to experience throughout your journey), and may give your investments more significant potential to grow in the long run.

Remember to think long term

Investing is thought to be something you do for the long term, and drip-feeding your account could be an easier way to build up money than just putting in one lump sum.

For example, imagine you had £10,000 to invest right now. It could be daunting to put that all in at once, but if you paid in an initial deposit of £4,000, then invested £50 a month for the next 10 years, your investment could be worth £13,462![1]

While that may not be a huge difference straight away, the longer you invest for, the more your investments could be worth.

What's more, your drip-feeding amounts don't need to be as large to have an impact, which could make it much more manageable to fit in with your lifestyle and expenses.

What if I take a break from investing?

Drip-feeding your investments could work best when you stick at it, as you're less likely to miss out on purchases during the dips that could be vital to smoothing out performance.

The thing you should be asking yourself here is why do you want to stop investing? It may make sense to take a break if you've had a change in personal or financial circumstances that means it's no longer feasible or necessary.

For example, if you have concerns over your employment, or if you're welcoming a new baby to the family, or you’ve managed to achieve your financial goals, such as buying a house.

If you’re planning on stopping regular contributions to your investment Plan because the value is falling, then you could remove some of the benefits that drip-feeding offers. This is because, when the market goes down, it gives you a better chance of buying ‘bargain’ investments.

If you were only to use this approach while markets are on the rise, you’re unlikely to smooth out any market bumps, and it could reduce the potential of your overall performance.

By combining a drip-feeding strategy with a diversified portfolio and a range of different investments – like shares, bonds, cash and property - the overall impact of market swings could be reduced so that you don't see the same rises and falls as the key market indexes.

At Wealthify, we always build diversified portfolios and change your different asset allocation depending on your chosen investment style and market trends. 

With investing, your capital is at risk, so the value of your investments can go down as well as up, which means you could get back less than you initially invested.

Wealthify does not provide financial advice. Seek financial advice if you are unsure about investing.

  1. This is the projected value for a Confident Plan (Medium Risk Plan) with an Original theme. This is only a forecast and is not a reliable indicator of future performance. If markets perform worse, your return could be £10,489. If markets perform better, your return could be £17,356. Values correct as of 18/07/23. 
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