When it comes to investing your money, there’s no shortage of simple rules that people tell you to follow. One of the best-known is that you should invest a fixed sum every month into a savings plan.
This is known as ‘pound cost averaging’, or sometimes ‘drip-feeding’. But is this rule worth following?
Pound-cost averaging certainly has a lot of practical advantages. In particular, it smooths out the ups and downs of the markets. If you invest a fixed amount each month, your money buys fewer shares when prices are high and more shares when prices are low. It is a useful way of taking the emotion out of investing, and it means you don’t have to guess the best time to buy.
Let’s say that you invest £200 per month over three months into a stock-market fund. For the first month, you invest at £10 per share; for the second, at £20 per share; and for the third, at £30 per share. The average share price over that period is £20 per unit, but the magic of pound-cost averaging means that you got a lower average buying price of £16.36. (Look at the table below to see how this works.)
And the reality is that for the vast majority of savers, there’s no real alternative to pound-cost averaging. That’s because they don’t have a lump sum to invest. Even if you do have a lump sum, the chances are you are also paying money into a pension scheme each month, which is a form of pound-cost averaging.
It’s also a lot easier – although still a stretch for most people – to put £1,250 a month into an Individual Savings Account, rather than investing your £15,000 allowance in one go.
That said, there are plenty of people who do receive significant lump sums of money – such as an inheritance, a cash payout from their pension fund, or a bonus. So it’s worth looking at whether these people should invest their money over a period of time rather than all in one go.
Which strategy works best?
A number of studies have compared pound (or dollar) cost averaging to investing a lump sum over the long run.
In 2012, US fund group Vanguard published a study looking at the performance of regular and lump-sum strategies across different markets (including the UK) and time periods. The UK study looked at investing £1m in one go, versus drip-feeding separate £1m sums in to the market in equal amounts overperiods of six, 12, 18, 24, 30 and 36 months.
Once fully invested, all the portfolios had the same asset allocation – ie, the same proportions were invested across different investment classes – and remained invested until a decade had passed. The study was carried out between the start of 1976 and the end of 2011.
Vanguard found that for two thirds of the time, a lump-sum strategy actually worked better than pound-cost averaging. UK lump-sum investors ended up with a savings pot that was, on average, 2.2% bigger than those who had gone for pound-cost averaging.
And not only did lump-sum investing make more money for investors, but it was less risky too – thanks to lower volatility (the lump-sum portfolio didn’t experience as many ups and downs, in other words).
The message seems to be that if the markets are going up, then get your money in to the market as quickly as you can. The trouble is, identifying if this is the case in advance isn’t easy. And that’s at least one very good reason to stick with pound-cost averaging.
The fact is that the differences between the two approaches – at least in the Vanguard study – were very small. The discipline of regularly saving money is still a great way to build up a pot of money for the future.
The big problem with lump-sum investing is that you may be tempted to try to ‘time the market’ – picking the exact right point to buy in.
However, it’s impossible to predict the future, and the chances are you’ll miss the best moment to invest, thinking that a better opportunity will come along. In other words, you’ll stay in cash for too long and damage your long-term investment returns as a result.
Pound-cost averaging avoids the danger of making this mistake. And it works well when markets go down (because you get to buy more and more shares at lower and lower levels), and so should keep risk-averse investors happy. However, to get the most out of it you need to do two very important things.
Firstly, you need to have the discipline to stick with it through good and bad times. Can you really keep putting money in to markets that are in turmoil? It’s all too human to panic and sell when the markets are diving. Yet for pound-cost averaging to work you have to have the courage to buy when the investment herd is at its most pessimistic.
Secondly, you need to account for inflation. Successful investing is all about growing the buying power of your money. By increasing your regular savings amount in line with inflation each year, you will stand a better chance of growing the real (after-inflation) value of your pot.
|Effect of pound-cost averaging over three months|
|Month||Amount invested||Average share price||Units bought|