Pound cost averaging

Pound cost averaging – also known as drip feeding – is no exception. It simply means investing a sum of money into the market at regular intervals rather than in one go. So if you have £1,200 to invest this year, you might invest £100 per month. If you have £12,000, you invest £1,000 per month. The advantage of investing this way is that it may reduce the risk (and pain) of buying just before the market drops.

If you put all your money in UK shares this month and the FTSE 100 drops steadily over the next year to end up down 30%, your portfolio is also down 30%. If you invest equal amounts monthly, you are buying at a lower price each time and reducing your average cost. Your portfolio may end the year down by around 15% rather than 30%, which may make it easier to hold your nerve and wait for the recovery.

Obviously, if markets rise rather than fall over the time that you are averaging your investments, you will make smaller profits than you would if you invested a lump sum at the start. Critics point out that most major markets have risen substantially in the past few decades, so studies show that consistently following a pound cost averaging strategy has not delivered the best long-term returns. It might do better than lump-sum investing if the market declined steadily over the long term, but the best outcome in that case would be not to invest at all.

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However, the behavioural benefits of pound cost averaging mean it can be useful, especially during a crisis. Whether it ultimately produces better returns than investing a lump sum will depend on if you begin closer to the start or end of the crisis, but a disciplined approach to investing small amounts can help overcome the inertia and fear that might stop you entering the market at all until the best of the recovery is over.