Benefits of pound cost averaging

Benefits of pound cost averaging

In times of market volatility, investors often succumb to emotional decision-making in an attempt to safeguard their assets and minimise losses. However, there exists a straightforward strategy to mitigate the impact of market fluctuations—pound cost averaging.

Despite its seemingly complex terminology, pound cost averaging is a simple concept. If you have a monthly Direct Debit set up for your investment account, you are already implementing this strategy, sometimes referred to as ‘drip-feeding’ by Wealthify.

Pound cost averaging involves consistently investing small amounts of money over time. The rationale is to eliminate emotionally-driven reactions to financial markets, focusing on steady contributions rather than market highs or lows. This not only cultivates a disciplined saving habit but also has the potential to smooth out market volatility.

The core idea behind pound cost averaging is its potential to provide protection when the market experiences a decline shortly after an investment. By spreading investments over different time points, investors may benefit from purchasing assets at various prices, capitalizing on market fluctuations.

For instance, if you had invested in the FTSE 100 in February 2020 and the market dropped by 30% by March, a drip-feeding approach could have allowed you to buy investments at two different prices, potentially increasing the number of shares acquired.

While investing is a long-term endeavor, drip-feeding offers a gradual way to accumulate wealth compared to a lump sum investment. For example, investing £10,000 at once can be intimidating, but an initial deposit of £4,000 followed by monthly investments of £50 over ten years could result in a total value of £13,462.

The sustained practice of drip-feeding investments is crucial for its effectiveness. Stopping regular contributions, especially during market downturns, may negate the benefits of purchasing investments at lower prices. A break in investing may be justified in the face of significant life changes or achieving financial goals, but halting contributions due to market declines may hinder the strategy’s potential. Combining drip-feeding with a diversified portfolio—including shares, bonds, cash, and property—further mitigates the impact of market swings, potentially resulting in a more stable overall performance compared to key market indexes.