Imagine you have a big chunk of money you want to invest. Pound cost averaging is an investment strategy where you invest it little by little over time, instead of all in one go. This helps to spread out the risk of investing your money.
Got a big chunk of money? Hooray! Want to invest it? Good decision.
But you might be wondering: should I invest it all in one go? Or should I spread it out and invest it little by little, known as pound cost averaging (or dollar cost averaging in the US)? It’s a tough call but here’s some info that should help.
What exactly is pound cost averaging?
If you have a big chunk of money (maybe you’ve sold your house or you’ve received some inheritance) and you want to invest it, you have two options:
Invest it all in one go (as a single lump sum investment).
Invest it little by little, making regular payments over time (‘drip feeding’).
Pound cost averaging is the second option: instead of investing that sum of money in one go, you spread it out and invest it in smaller chunks as regular contributions over a longer period of time (when investing for the long term). You effectively drip feed your money into investments. This could be over the course of a few weeks, a few months or even many years.
Pound cost averaging shouldn’t be confused with investing a percentage of your income. Investing a percentage of your income each month will come with the same benefits as pound cost averaging as you’ll be investing smaller amounts on a regular basis. However, it works a little differently as you’re investing your money as it comes in rather than storing a big chunk of money in a savings account and taking small amounts out to invest little by little.
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Pound cost averaging is a way of spreading out the risk of investing your money in the stock market (and other investments), and of trying to even out the ups and downs of the stock market.
Let’s rewind a little. When you invest, you’re buying things like stocks and shares (which are essentially ownership stakes of companies) so that when they (hopefully!) increase in value, you’ll make more money.
In an ideal world, the value of your investments would always climb up and up as the market rises. But in reality, the market will go up and down (called market volatility) and the average value of shares will also rise and fall accordingly (markets almost always go up in the long run though, so if you leave your money invested for long enough and you’ve chosen your investments wisely, you should still increase your savings!).
Let’s say you decide to invest your whole chunk of money in one go as a lump sum investment. Now imagine that the next day, the market drops and all your investments decrease in value.
Before you start panicking, it’s not the end of the world. They’ll hopefully still increase in value again later down the line. But the annoying thing is that if you’d waited an extra month, you could have bought those same stocks and shares (or whatever kinds of investments you made) for less money. And therefore, you’d have made even more money when they eventually increased in value. Annoying, right?
Well now let’s say that instead of investing your whole chunk of money in one go as a lump sum investment, you instead set up a recurring payment so you’re investing it in smaller chunks over a longer period of time. Let’s again imagine that the next month, the market drops.
Well, guess what? Because you only invested a small amount of your money while the market was up, that means you have the rest of your money free to invest at lower prices now the market is going down. Kerching!
Now, it’s important to note that if the market is going down, you’re still losing money (remember, your investments are decreasing in value). However, when the market goes up again, your investments will increase in value. And if you bought them for less because of your regular contributions, that means you’re making a bigger return (more money).
In this way, pound cost averaging is a way of hedging your bets so that you’re not putting all your eggs in 1 basket.
What are the benefits of pound cost averaging?
Pound cost averaging (drip feeding your money into investments) has some pretty convincing benefits besides just helping you to hedge your bets. Here are the main ones.
Less scary. If you’re not an experienced investor, you might be a bit nervous about investing your money. After all, even though it’s a sensible thing to do, there’s always a risk that your money loses value instead of making money for you. Pound cost averaging can be less scary as it means you’re not saying goodbye to that whole chunk of money all at once (so it’s a good way to stop yourself from putting off investing!).
Even out the ups and downs. If the market is doing well, the shares you buy will be more expensive than if the market is doing badly. As markets are constantly going up and down, pound cost averaging will mean you buy shares at both more expensive and at cheaper rates, averaging out the cost you end up paying for them and making the swings up and down less extreme.
Good during volatile times. When the market is volatile, that means it’s likely to make big jumps up or down without much warning – like during the pandemic! Pound cost averaging can be especially useful in times like this because the risk of buying stocks just before they drop in value (and therefore losing out on buying them for less) will be higher.
What are the negatives of pound cost averaging?
While pound cost averaging has its perks, it’s not all roses and sunshine. And to be honest, there are many people who aren’t big fans. Should you jump invest as a lump sum instead? Here are the negatives.
Not so good when markets go up. Pound cost averaging can work well if the market is going down but it’s not so good if the market is on the rise. If the market’s going up, you’re better off investing your lump sum at the start so you avoid paying more for your investments tomorrow or next month. Oh, and it’s worth noting that markets go up more often than they go down!
Risk of delaying the benefits of investing. As a general rule, the longer you leave your money invested for, the better. Markets tend to increase over time, so if you leave your money invested for long enough, it’s very likely to go up in value in the long run despite occasionally falling in the short term. Pound cost averaging means you’re delaying investing some of your money, which means you’re giving it less time to grow.
Inflation can be an issue. Inflation refers to how goods and services get more expensive in an economy over time. Pound cost averaging can mean leaving a large chunk of your money sitting around in your bank account as cash, waiting to be invested. Because of inflation and the fact that cash savings currently have very low interest rates (meaning they won’t grow much if at all), your cash could end up going down in value while it’s sitting there (in other words, the same amount of cash will be able to buy you less as goods become more expensive).
Is pound cost averaging a good idea?
So, is pound cost averaging a good idea? Well, it’s impossible to give a straight yes or no answer as it all depends on you, your attitude to risk and the market!
Are you a nervous investor? If you want to invest but you keep getting cold feet, a pound cost averaging strategy could be a great solution for you and your investment decisions. Investing smaller amounts over a longer period is often less scary than investing your whole chunk of money all at once. So, it’ll probably make it easier to take the plunge and start growing your money!
The same goes if markets are currently volatile and you’re nervous about the market making a big drop right after you’ve invested your money. Pound cost averaging can help you to spread your bets and even out those ups and downs so you can be more sure of your returns.
That said, it’s important to remember that markets go up more often than they go down! So, even though pound cost averaging can be useful in some situations, it can mean you end up paying more for those stocks and shares overall rather than less.
Plus, remember that pound cost averaging will mean having to store the money that you’re not yet investing in a generic savings account. Thanks to inflation and current bad interest rates, leaving that cash sat around for too long will usually mean it’ll lose value as goods get more expensive over time.
One thing we will say is this. If you do decide to go with pound cost averaging, we’d recommend setting yourself a strict timeframe to complete your investments. That way, you can avoid your money sitting around for too long as cash, and set it to work making you a return sooner rather than later!
If you have a big chunk of money that you’re looking to invest, pound cost averaging can be a great way of hedging your bets to make sure you’re not investing all your money right before the market drops. But there’s no official best strategy, it’s up to you.
Warren Buffett (a very successful investor) once said “it’s time in the market, not timing the market”, and we think this is great.
Instead of trying to ‘time the market’ by investing a lump sum of cash as an entire investment when you think it’s the best time, if you make regular payments of regular amounts you can benefit from simply being in the market over time. You don’t have to worry if the market declines and falls (that’s better for your future performance as it will bring your average price down).
Ultimately, no matter what investment strategy you choose, lump sum investing or investing small amounts over time – it’s sure to be better than leaving your money sitting around not working for you. The longer your money is in the market, the more potential you have for growth in the future.
A good investment strategy is to invest a part of your monthly salary each month with regular contributions into your investment account – it will soon add up and potentially turn into large amounts in future.
Just remember the best strategy is long term investing. That’s why trying to time the market becomes much less important. And past performance is not a reliable indicator of future performance. Even if the market conditions seem great, you can never really know. Timing the market is very difficult.
As far as we’re concerned, the most important step is making the choice to invest your savings in the first place. So, congrats. You’re part way there already!
If you’re still unsure what’s best for your financial circumstances. You can always speak to a financial advisor – check out Unbiased¹ to find the best one for you.
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