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 minutes

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 into your investment account, you're already doing it! Pound cost averaging is simply the strategy of regularly investing small amounts 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 the 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. In essence, sometimes you'll buy low, 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, by opening a Wealthify Stocks and Shares ISA, setting up a Direct Debit, and then letting our experts build and manage your investments. If you've decided to pick your own investments, this will become a bit trickier, as you'll need 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 provides a bit of protection in case the market drops shortly after you've invested. For example, say you invested in a way that tracked the FTSE100,  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. But, if you'd invested a smaller amount in February and then invested again in March, you could have benefitted from this dip – purchasing 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 lets you regularly take advantage of any dips and gives your investments more significant potential in the long run.

Remember to think long term
Investing is for the long term, and drip-feeding your account could build up more money than just putting in one lump sum. The easiest way to look at this would be to imagine you had £10,000 to invest right now. If you put the full amount into a Wealthify Stocks and Shares ISA, then in 10 years your investments could increase in value to £13,605.[1] However, if you invested the £10,000 and also set a Direct Debit to pay in £80 each month, that could increase your potential earnings over 10 years to £24,832![2]

That's a big difference, and the longer you invest for, the more your investments could be worth. What's more, these 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 typically works best when you stick at it, as you're less likely to miss out on purchases in 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. Drip-feeding is a strategy that works best if maintained over a long period. 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.

  1. This is the projected value for a Confident Plan (Medium Risk Plan). This is only a forecast and is not a reliable indicator of future performance. If markets perform worse, your return could be £9,468. If markets perform better, your return could be £18,947. Values correct as of 19/03/2020
  2. This is the projected value for a Confident Plan (Medium Risk Plan). This is only a forecast and is not a reliable indicator of future performance. If markets perform worse, your return could be £18,813. If markets perform better, your return could be £32,352. Values correct as of 19/03/2020

 

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