Jasmine Birtles
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What is pound-cost averaging? And is it a good way to invest?
Karl
17th Aug 2023
Pound-cost averaging is an investing strategy where you buy shares at regular intervals regardless of market performance. But what are the benefits of drip-feeding your portfolio over investing a lump-sum?
In this article we’re going to take a closer look at pound-cost averaging, including how it works, plus the pros and cons.
Keep reading for all the details or click on a link below to jump straight to a specific section…
What is pound-cost averaging?
Pound-cost averaging refers to regularly contributing to your portfolio, irrespective of market movements.
The logic behind pound-cost averaging is that while the stock market will rise and fall, the average cost of buying shares at consistent intervals should even out in the long run.
Because pound-cost averaging means investors can pick up stocks ‘cheaply’ when the market falls, it’s particularly popular among risk-averse investors who may wince at the thought of investing a huge lump-sum in one go. That’s because when investing a lump-sum, the value of your portfolio could take a big hit if the stock market takes a turn for the worse shortly after you invest.
Pound-cost averaging: An example
John Jackson has a pile of cash sitting in his bank account earning a pitiful rate of interest. John has read up about the benefits of investing so is keen to put his capital in the stock market in order to seek higher returns.
However, John is risk-averse. He’s worried that if he puts all of his capital into the stock market in one go, he might lose a significant chunk of his wealth if the stock market tanks over the coming weeks or months.
Because of this, John would prefer to drip-feed £200 into his portfolio each month, via an index tracker fund.
John knows that by doing this, his fixed £200 monthly investment will buy him more shares after the stock market experiences a bad month, and less shares when the stock market has a good month. Over time, John understands there’s a good chance his fixed £200 monthly investment will capture the ‘average cost’ of buying his shares.
By taking a pound-cost averaging approach, John is able to gain exposure to the stock market, while limiting the risk of his portfolio suffering a colossal crash shortly after he starts investing.
What are the benefits of pound-cost averaging?
Now we’ve explained what pound-cost averaging is, let’s take a look at the benefits of regularly drip-feeding your portfolio.
1. Reduces impact of market volatility.
Pound-cost averaging can reduce the impact of market volatility on your investments. That’s because by investing a fixed amount at regular intervals, you essentially avoid the pressure of trying to ‘time the market,’ which is a notoriously difficult thing to do.
Instead, you’ll be sticking to a strategy that requires you to contribute a set sum to your portfolio each month, come rain or shine.
In contrast, if you don’t invest at regular intervals, and instead invest a lump-sum, then the value that you ‘buy in’ will have a far greater impact on your overall returns when the time comes to sell your investments. This puts you at greater risk of seeing your portfolio slide should the stock market plummet, or even crash.
2. Helps to kick-start a healthily investing habit.
If you’re keen to grow your wealth, then regularly investing can be an excellent way to go about it – especially if you can maintain a long-term horizon.
Because a pound-cost averaging approach encourages you to make consistent contributions to your investments, it can be a an effective strategy for those who may otherwise struggle to save into their investments, or make one-off payments.
3. Helps keep your emotions at bay.
Pound-cost averaging enforces a disciplined investment strategy. Whether the stock market rises or falls, you put the same fixed amount into your portfolio at set intervals. This should, hopefully, mean you won’t be tempted to buy big during a rising market, or offload stocks during a downturn – and this is almost certainly a good thing!
Emotions and investing don’t mix, so sticking with a pound-cost averaging strategy can be an excellent way to put your feelings aside and instead focus on building your wealth over time through the power of regular investing.
To learn more about this, take a look at our article that explains why you should keep your emotions at bay when investing.
What are the drawbacks of pound-cost averaging?
Any type of investing strategy has its downsides, and pound-cost averaging is no exception. Here are some of the potential drawbacks of drip-feeding your portfolio each month.
1. You could miss out on quick gains.
Pound-cost averaging isn’t for those who wish to trade stocks in order to earn a quick profit. That’s because the strategy is designed for passive investors with a long-term investment horizon who are aiming to capture average market returns over time. In other words, trying to ‘beat the market’ isn’t on the menu.
That said, there are certainly active investors out there who do manage to earn themselves above-average returns, and a lot of these investors will be short-term traders looking to capitalise on short-term swings in the stock market.
Therefore, it’s fair to say that one of the potential downsides of pound-cost averaging is that there’s no real possibility of being on the right side of short-term market swings. So if you’re looking to ‘play’ the markets then the strategy isn’t for you.
2. The strategy can be costly in bull markets.
In a prolonged bull market, where stocks consistently rise, pound-cost average investors may find themselves paying a higher cost per share than the current market price. The longer the bull market goes on for, the more expensive these shares will become.
While bull markets don’t last forever, this drawback is certainly something that all of pound-cost averaging investors should be aware of.
3. Fees can be higher compared to investing a lump-sum.
Yes, fees are part and parcel of investing, but it’s important to note that fees vary by broker.
For example, some brokers will offer 0% commission trading, and will make their money by charging a high platform fee. Others will charge a lower platform fee, but will charge for each trade in the form of a ‘share dealing fee’.
If brokers charge a fee for every trade, this can turn out to be very costly for investors who regularly contribute to their portfolio. That’s because these investors will be charged each and every time they buy shares. For brokers like this, lump-sum investing is typically a cheaper way to invest.
The takeaway here is that pound-cost averaging investors should pay very close attention when picking their investment broker to ensure their strategy won’t end up costing them a small fortune in fees.
For more on this topic, take a look at our article: Share dealing fees vs platform fees: which is more important for investors?
How to set your own investing strategy
While pound-cost averaging is a popular way to invest – especially for those who invest through an index tracker fund or ETF – the strategy isn’t without risk. As with any type of investing the value of your portfolio can rise or fall.
However, if you like the sound of pound-cost averaging, then it’s important to note that there are many other factors worth taking into account before you invest your hard-earned capital.
To learn more about investing, including how to set your investment goals, suitable time horizons, and tips for picking the right broker, take a look at our comprehensive article that explains How to create your own investing strategy in 5 simple steps.
And while we’re at it… do you want to be kept informed about the latest investing news, tips and insights? If so, why not sign up for our fortnightly MoneyMagpie Investing Newsletter? It’s free and you can unsubscribe at any time.
Disclaimer: MoneyMagpie is not a licensed financial advisor and therefore information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This should not be considered as financial advice. Anyone thinking of investing should conduct their own due diligence.
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