Too embarrassed to ask: what is pound-cost averaging?
“Pound-cost averaging” might sound complicated, but it simply means investing into the market at regular intervals. Here's how it works.
Many concepts in investing sound far more complicated than they are. “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 a month; if you have £12,000, you invest £1,000 a month.
The advantage of investing like this is that it can reduce the risk – and pain – of buying just before the market drops. For example, if you put all your money in UK shares this month and the market drops steadily over the year to end up down 20%, your portfolio will also be down 20% (ignoring dividends).
But if you invest equal amounts monthly, you buy in at a lower price each time and so reduce your average cost. So your portfolio may end the year down by around 10% rather than 20%. In turn, that’s less painful, which may make it easier to hold your nerve and wait for the recovery. If markets rise rather than fall over the same period, you will of course make smaller profits than you would have, if you had invested a lump sum at the start.
Critics of pound-cost averaging point out that most major markets have risen substantially in the last few decades. As a result, pound-cost averaging has not delivered the best long-term returns. However, a useful lesson to learn about investing is that the best strategy is not the one that’s best in theory, but the one you can actually stick with in practice.
In an ideal world, we would calmly stick to our plans through thick and thin. But it’s easy to panic in a crash when you see your portfolio’s value falling. Following the pound-cost averaging route – rather than committing all of your money at once – may help you to stay invested during a crisis, rather than pulling your money out at exactly the wrong point.
A disciplined approach to investing small amounts can also help you to overcome the fear that might stop you entering the market at all until the best of the recovery is over.
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