Building an investment portfolio: understanding pound cost averaging

Volatility and falling prices are the biggest fears for any investor. However, by investing smaller amounts over time rather than in larger single lump sums, you could buy investment units for cheaper on average, taking advantage of typical price volatility. But does pound cost averaging always work?

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
Pound cost averaging

What is pound cost averaging?

Pound cost averaging involves investing smaller amounts of capital over a period of time rather than a large sum in one go. As prices rise and fall as time goes by, spreading your investments out means you are likely to achieve a lower average cost of buying each investment unit. You are averaging out the peaks and troughs of price movements over time.

Why is this important? It’s all about market timing

The problem with the lump sum approach is that you are essentially trying to time the market: you’re hoping that you’ve got in at a low point from which markets will rise, increasing your capital. But even the world’s most famous fund managers admit they don’t have a crystal ball and can’t correctly time market peaks and troughs, so it’s unlikely an amateur investor can either. If you get it wrong, and markets take a nosedive just after you’ve invested your entire pot of capital, you feel the loss across your whole investment.

A strategy of investing smaller amounts regularly gives you a better chance of getting into the market at the right time, and gives you the opportunity to benefit from pound cost averaging.

Read more about whether it’s time in the market or timing the market

Smoothing your investment returns

The crux of pound cost averaging is that when markets fall, you are able to pick up more shares or fund units for your money because the price has dropped. Pound cost averaging is especially beneficial during times of volatility and falling markets. It gives you some protection as you only suffer losses on a small portion of your capital at once. It smooths out your returns because, even if the price of an asset fluctuates a lot over time, you are drip—feeding money in so you’ll be buying at different prices. This means your portfolio should perform better when markets recover.

More in this series:

Building an investment portfolio: ten things you need to know

Building an investment portfolio: why diversification is so important

Building an investment portfolio: the art of picking stocks

Building an investment portfolio: bonds, commodities and property explained

Building an investment portfolio: using ETFs to build a low—cost diversified portfolio

However, it also works the other way. When markets rise and share prices go up, you get fewer shares for your money. So if you take the ‘little and often’ approach to rising markets, chances are you will end up paying more per share on average than if you had invested a larger sum before markets began to rise. But again, no one knows exactly when markets will rise, so the chances of you getting in at the perfect time would be slim.

Is pound cost averaging a strategy for falling markets?

You can find plenty of figures ‘proving’ that regular investing is better than lump sum investing, and some which show the opposite, depending on where you look. For example, Vanguard’s research shows that lump sum investing is the right strategy because markets go up more often than they go down. It notes that, over the last 20 years, the stock market (represented by the FTSE All Share) has risen in 60% of individual months, and fallen in 40%. That means investors using pound cost averaging would be buying shares at increasing prices, an inefficient strategy.

Stock market movements chart

Robo—adviser Moneyfarm has also done some analysis, comparing a £13,000 lump sum investment with a monthly contribution of £1000 a month into a UK stock exchange traded fund (ETF). It found that drip—feeding works better. A lump sum investment strategy would have cost an investor £6.60 per share on average, and they would end up owning a total of 1969 shares. By contrast, with regular investing they would have paid an average of £6.25 per share and would own 2081 shares by the end of the period. This equates to a 5.4% discount in price terms.

Monthly contribution approach
Date Price Investment Unit
01/06/2017 £6.60 £1000 151
01/07/2017 £6.68 £1000 150
01/08/2017 £6.04 £1000 166
01/09/2017 £6.07 £1000 165
01/10/2017 £6.36 £1000 157
01/11/2017 £6.42 £1000 156
01/12/2017 £6.04 £1000 166
01/01/2018 £6.02 £1000 166
01/02/2018 £6.12 £1000 163
01/03/2018 £6.09 £1000 164
01/04/2018 £6.20 £1000 161
01/05/2018 £6.19 £1000 162
01/06/2018 £6.50 £1000 154
Average price £6.25 £13,000 2081
Lump sum investment on 01/06/2018 £6.60 £13,000 1969

Source: Moneyfarm

Pound cost averaging has the potential to dampen both losses and gains, but perhaps of greater importance is that it helps build a regular investing habit which can build long—term financial security. And you can’t put a price on that.

Get your free beginner's guide to investing

●  Discover the benefits of investing your money

●  Learn about the different investment options available and how to get started

●  Understand how to build a diversified portfolio and manage your risk

Form has failed to submit. Please contact IG directly.

  • I’d like to receive information from IG Group companies about trading ideas and their products and services via email.

Get my guide

For more info on how we might use your data, see our privacy notice and access policy and privacy webpage.

Form has failed to submit. Please contact IG directly.

  • I’d like to receive information from IG Group companies about trading ideas and their products and services via email.

Get my guide

For more info on how we might use your data, see our privacy notice and access policy and privacy webpage.

●  Discover the benefits of investing your money

●  Learn about the different investment options available and how to get started

●  Understand how to build a diversified portfolio and manage your risk

Get your free beginner's guide to investing

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.