One of the fundamental principles of investing is to put your money to work as soon as possible. An investment needs time to grow, so the longer your money is in the market, the more chance you have of reaching your goals.
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You might interpret this as an argument in favour of investing a lump sum, but sometimes making regular investments can work in your favour, thanks to what’s known as ‘pound cost averaging’. Be aware though that it won’t always work and sometimes it can produce worse results.
What is pound cost averaging?
Pound cost averaging is a technique that involves investing a fixed amount of money on a regular basis. So for example, say you have a lump sum of £10,000 that you want to invest in a particular share or fund valued at £100. You have two options.
First, you can invest the full £10,000 in one go, buying 100 shares, at £100 each. But by doing this you’re fully exposing yourself to the market and the value of your investment will rise and fall in line with any share price changes.
Your second option is to invest your money gradually. You may, for example, choose to invest £1,000 a month over 10 months. If the share price stays the same, this means you’ll be able to buy 10 shares each month (10 shares at £100). But the key here is that as you slowly drip-feed in your money, any movement in share price has less effect on the value of your investment - in other words, by regularly investing you’re less likely to fall foul of any volatility.
However, share prices rarely stay the same for long. So when you invest regularly, you end up buying more shares when prices fall (and vice versa). If the share price drops to £90 at the point you invest, you’ll buy 11 shares, whereas if it rises to £110, you’ll buy nine shares.
But there are a couple of things to bear in mind before you decide whether regular investing is right for you. First, you receive a smaller proportion of any income generated by your investments, such as dividend payments. And second, regardless of which approach you take, your money is at risk. The value of your investment can fall as well as rise and you may not get back the amount you invest.
Advantages and disadvantages of making regular investments
There are strong arguments in favour of making regular investments rather than investing a lump sum, but there are some against it, too.
Smooth out market volatility
Financial markets rarely move in a straight line. Prices move up and down, sometimes on an hourly basis. By drip feeding your money into an investment over a period of time, you invest across a range of prices. So, you effectively pay the average price over a fixed period, which can help smooth out market volatility.
Value for money
When making regular investments, your buying power increases when the share price falls.
Let's return to the example at the start of the article. You're trying to decide whether to invest £10,000 as a one lump sum, or gradually over the course of 10 months. The share in question is currently priced at £100.
The table below shows the effect of pound cost averaging. Over the course of 10 months, you invest £1,000 per month buying a total of 104 shares. You buy one extra share when the price falls to £90 and one less when the price rises to £110 (although the profit from the shares bought at £90 makes up for the shortfall). When the share price recovers to £100 in the last month, your original investment is worth £10,400. This means you're £400 better off from investing regularly compared to if you invested a lump sum in the first month and bought 100 shares
Pound Cost Averaging Lump sum