Pound cost averaging
Pound cost averaging, also known as drip-feed investing, is a technical term for a simple way of investing money. It involves regularly ‘drip feeding’ your contributions into, for example, an investment fund, rather than investing a single lump sum.
Making regular contributions like this allows you to buy into the fund at different prices throughout the term of your investment. This is due to the way markets can rise and fall over time.
Pound cost averaging explained
Keeping with this example, when you invest in a fund, your money buys ‘units’ of that fund. The price of these units changes depending upon the performance of the fund’s underlying assets. That means your regular investment will sometimes buy you more units (when market prices are low) and sometimes less (when the market prices are high).
At the end of your investment’s lifetime, you would have an average price per unit paid, based upon the overall cost divided by the number of units held. This is where the term pound cost averaging comes from.
A potential benefit of pound cost averaging is the protection it can provide against the loss of value in markets that, by nature, can fall as well as climb. Instead of investing a sizeable chunk at a single point in the market, only to see prices potentially fall thereafter, regular contributions would buy units as the underlying asset prices decreased.
This would result in more units for your money, which would provide a greater return should market conditions improve and prices begin to climb.
Naturally, the opposite may also apply, where markets rise following a lump sum investment. This could lead to greater returns than drip-feeding your money, because your regular contributions would now be buying units at higher prices.
Bear in mind all investments can go down as well as up, and you may get back less than you put in.
Pound cost averaging vs lump sum investing
If you had a set amount of money you wished to invest, pound cost averaging and lump sum investing are two of the ways you could go about it.
Lump sum investing
With lump sum investing, you would take your money and invest it all at once, for example in a fund or buying shares. You would pay the market price as it was at the point of purchase and rely on time being kind to your chosen investment.
So, if you had £10,000 set aside to put into an investment fund and the price at the time of investment was £2.50 per unit, your money would buy 4,000 units. You would be free to invest further at any point of course, but any subsequent unit price changes would affect your initial 4,000 units equally.
Pound cost averaging
With pound cost averaging, you wouldn’t invest everything at once. Instead, you’d make regular contributions, perhaps eventually investing £10,000 over time.
For instance, let’s say you take the same investment fund as in the previous example and make monthly contributions of £167. After five years, you would’ve invested the same amount (£10,000) as the lump sum investor. Your first purchase, at £2.50 per unit, would buy 66.8 units in the fund, but from then on, the number of units your money buys each month would depend upon the current unit price. When the unit prices drop, you’d receive more units for your £167; when they rise, you’d receive less.
The table below illustrates pound cost averaging over the first year of a £167 monthly investment. Please note that the unit prices are strictly illustrative and not based on any real world examples or projections. For simplicity, no charges have been included.
| Month | Monthly contribution | Unit price | Units bought |
|---|---|---|---|
| 1 | £167 | £2.50 | 66.8 |
| 2 | £167 | £2.00 | 83.5 |
| 3 | £167 | £1.50 | 111.3 |
| 4 | £167 | £2.50 | 66.8 |
| 5 | £167 | £3.00 | 55.7 |
| 6 | £167 | £3.25 | 51.4 |
| 7 | £167 | £2.50 | 66.8 |
| 8 | £167 | £2.00 | 83.5 |
| 9 | £167 | £1.75 | 95.4 |
| 10 | £167 | £1.50 | 111.3 |
| 11 | £167 | £2.00 | 83.5 |
| 12 | £167 | £2.50 | 66.8 |
With the fluctuations in unit prices over the course of 12 months, the cost per unit averages to £2.13, with 942.8 units purchased. Had the same amount (£2,004) been invested as a lump sum in the first month, it would’ve cost £2.50 per unit, with only 801.6 units bought.
As this is only an illustrative example, there is no guarantee that pound cost averaging would result in a cheaper average unit price over the long term. For instance, investing a lump sum could work out the more cost-effective option if unit prices continually rose throughout the period of your investment.
What are the advantages of pound cost averaging?
As with any form of investing, there’s no guarantee of a positive return when it comes to pound cost averaging. There is, however, the potential for:
- The price per unit (or share) to average out cheaper than if you were to invest with a single lump sum
- A degree of protection against market volatility due to lower prices buying more units. Should the market pick up and underlying asset prices start to rise again, you will have a greater number of fund units (or shares) to sell, which, in turn, could potentially result in a greater return.
Potential disadvantages of pound cost averaging
Aside from the general risks associated with investing, such as getting back less than you put in, there are some potential disadvantages specific to pound cost averaging. These include but aren't limited to:
- Slower growth and potentially lower returns compared to lump sum investing, due to smaller amounts being invested gradually over time
- Units bought towards the end of an investment not having the timeframe to potentially grow.
Although there are drawbacks to pound cost averaging, the drip-feed approach may suit you if you don't wish to risk a large amount of money in a single go and you're prepared to remain invested long term.