Pound cost averaging sounds like investment jargon, but it’s actually a powerful tool. The idea is that instead of investing your money all in one go, you drip feed it into the market over a period of months or years. This has benefits both from a financial point of view and psychologically.
So how does it work, and how can you incorporate pound cost averaging into your investment plan?
What is Pound Cost Averaging?
The idea behind pound cost averaging is simple. It means that you invest regularly over a period of time, during which, the market will rise and fall.
If share prices go up, your existing pot will benefit as the value will rise. But if prices go down, you will be able to buy more shares with your regular investment, boosting your eventual fund value.
Let’s take a very simple example:
Lump Sum Investor
| Month | Share Price | Investment | Shares Purchased |
| 1 | £1.00 | £400.00 | 400.00 |
| 2 | £0.75 | 0.00 | |
| 3 | £0.95 | 0.00 | |
| 4 | £1.25 | 0.00 | |
| Total | £400.00 | 400.00 | |
| Fund Value | £500.00 |
Monthly Investor
| Month | Share Price | Investment | Shares Purchased |
| 1 | £1.00 | £100.00 | 100.00 |
| 2 | £0.75 | £100.00 | 133.33 |
| 3 | £0.95 | £100.00 | 105.26 |
| 4 | £1.25 | £100.00 | 80.00 |
| Total | £400.00 | 418.60 | |
| Fund Value | £523.25 |
In this scenario, the market dips shortly after the first investment. The lump sum investor loses money in the first instance, although the market eventually recovers and they start to see returns.
The regular investor also loses money in the first month, but because they haven’t put all of their money into the market, the impact is lessened. In month two and three, they can actually buy more shares due to the reduced prices. They eventually end up better off than the lump sum investor as they have benefited from both the high and the low points in the market.
Of course, if share prices had steadily risen, the lump sum investor would have ended up with a larger pot. But while prices do tend to increase over the longer term, this never happens in a straight line. We expect to see ups and downs on a monthly basis.
The monthly investor has also reduced some of the risk. As the lump sum investor discovered, the market can fall at any time. If this happens just after you invest, it can take some time for the funds to recover.
The Psychological Benefits
Pound cost averaging is also a useful tactic from a psychological perspective.
Firstly, investing every month is a good habit to get into. You are more likely to stick to an investment plan if you set up a direct debit and avoid thinking about it too much. This helps to build discipline without too much effort.
Additionally, pound cost averaging means that you are not having to make decisions about when to buy and sell. There is no best or worst time to invest as the fluctuations happen daily. Trying to time the market is not only mentally draining, but it is rarely effective. By the time the public becomes aware of something that could affect a share’s value, it is already priced in. Any advantages gained due to market timing are purely down to luck, and are unlikely to be sustainable for the long-term.
Investment decisions can sometimes be driven by emotion. Investors may feel that they should invest more when the market is rising, and may be tempted into selling when things take a downturn. Getting it wrong (which happens more often than not) can be devastating, particularly if you are investing a significant sum. Investing regularly, through the ups and downs, can ease some of this pain.
A good investment plan thrives on discipline rather than emotion. Pound cost averaging can help to instill this.
What If You are Investing a Lump Sum?
If you invest a lump sum, and the market steadily rises, your investment will grow. But the market could just as easily fall the day after you invest. There is a strong chance that it will recover eventually, but it will take some time.
Lump sum investors can still benefit from pound cost averaging. You can drip feed your investment into the market over a period of months. In the meantime, you will be earning interest on your cash.
You may wish to consider this if you are investing a large amount or if you are nervous about investing all in one go.
Other Ways to Boost Your Returns
Pound cost averaging can boost your returns over the longer term, as well as mitigating some of the risks. However, there are a few other tips you can use to improve your returns:
- Compound growth – this means that you receive growth not only on your initial capital, but also on all of the returns you have made. This can exponentially increase growth potential.
- Reinvest dividends – if you reinvest the income made on your investments, this can provide an added boost to your compound growth.
- Increase your investment – if you increase your monthly investment in line with inflation (or even higher), there is a good chance that you will barely notice. But if you do this consistently, you could increase your returns. If you are able to automate this, for example, if your provider allows you to build in annual increases, even better.
- Invest across the market – deciding what to buy and sell takes time and energy, and does not always yield the best results. Investing in a diverse range of assets over the whole market allows you to benefit from growth, while avoiding too much concentration in one area.
If you need some help with your investment strategy, or would like an objective view of the best options, it may be worth seeking financial advice.
The content in this article was correct on 21/04/2023.
The value of your investment can go down as well as up and you may get back less than the amount invested
Past performance is not a guide to future returns and you might get back less money than you have invested.
You should not rely on this article to make important financial decisions. Teachers Financial Planning offers independent financial advice on savings, pensions, investments, mortgages and equity release for teachers and non-teachers.
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