If you’ve ever felt unsettled when the stock market starts to wobble, ‘pound-cost averaging’ might be the steady strategy you need.
It might sound like something from a maths lesson, but it simply involves making a series of investments over time. This approach can be particularly useful during turbulent periods, smoothing out the market’s ups and downs and helping you keep calm.
Here, we explain how pound-cost averaging works and some of the pros and cons compared with lump sum investing.
What is pound-cost averaging and how does it work?
Instead of investing a lump sum all at once, pound-cost averaging is where you spread out your investment by investing smaller, fixed amounts at regular intervals. This helps to even out fluctuations in share prices because you buy more shares when prices are low and fewer shares when prices are high. Over time, this can lead to a lower average cost per share.
Imagine you invest £100 every month. One month, you might get 10 shares at £10 each. The next month, if the price drops to £5, you’ll get 20 shares. So, you end up with an average cost of just £6.67 per share.
If you’re contributing to a workplace pension, you’re already practising pound-cost averaging. Although those contributions are regular savings, as opposed to spreading out a lump sum investment, the principle remains the same.
How does it differ from lump sum investing?
Lump sum investing involves putting a large amount of money into the market all at once. While this can be better in the long run (more on that below), it means you’re fully exposed to whatever the market is doing that day. If the stock market is high when you invest, you might buy shares at a higher price, which isn’t ideal if it takes a nosedive later.
Pound-cost averaging, on the other hand, is like taking small, steady steps. You’re not trying to time the market or guess when it’s going to go up or down. Instead, you’re consistently adding to your portfolio. This can be a lot less stressful, especially if you’re new to investing.
What are the benefits of pound-cost averaging?
Some of the benefits of pound-cost averaging include:
Smoothing out the bumps
Pound-cost averaging can help to smooth out the performance of your investments over time. By investing regularly, you’re less affected by short-term market fluctuations, which can lead to more consistent returns.
Keeping your cool
Market ups and downs can be nerve-wracking. Pound-cost averaging can help you stay calm and focused on your long-term goals. You’re not worrying about whether you should buy or sell or reacting to short-term price movements.
Building good habits
It’s good practice to invest little and often, so if you decide to invest a lump sum over several weeks, months or years, you’ll be building habits that will serve you well throughout your investment journey. Regular investing is especially beneficial for long-term goals like retirement.
Are there any disadvantages compared with lump sum investing?
Although pound-cost averaging has its benefits, there are some potential drawbacks to be aware of. For example, research by Vanguard has shown that lump sum investing tends to outperform pound-cost averaging over long periods1. This is because markets typically rise over time.
If the market is on an upward trend, lump sum investing can give you higher returns because you’re fully invested from the start. With pound-cost averaging, you might miss out on some of those gains, resulting in lower overall returns.
Ultimately, there’s no one-size-fits all approach to investing. Pound-cost averaging can result in a smoother performance and provide valuable peace of mind. Lump sum investing might outperform over the long term, but you’re more exposed to market downturns in the short term.
What should I do when markets are bumpy?
Whether you decide to invest a lump sum, make regular contributions or combine the two approaches, the key is to stick to your plan, even when the market gets a bit bumpy.
It’s important to remember that stock market ups and downs are a natural part of investing. Although your investments could go down as well as up, history shows that, over long periods, shares rise in value and typically deliver better returns than cash.
For more information on how to navigate the market’s ups and downs, visit our market volatility hub. You can also find out how to set up a regular payment through your Vanguard account.
1 Megan Finlay and Josef Zorn, Ph.D., CFP®. Cost averaging: Invest now or temporarily hold your cash. Vanguard, February 2023.
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