How pound-cost averaging can help in choppy markets

Feel unsettled by dips in the stock market? Pound-cost averaging can be a steady hand on the tiller when things get choppy.

We explain what pound-cost averaging is, how it works and what the pros and cons are.  

What is pound-cost averaging and how does it work?

Pound-cost averaging is when you invest a lump sum gradually – by spreading it into regular, fixed payments – rather than all at once.

This helps 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 contribute to a workplace pension, or have a Direct Debit paying into your ISA, you’re already practising pound-cost averaging. While those contributions are regular savings, as opposed to spreading out a lump sum investment, the principle’s 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?

These are some of the benefits of pound-cost averaging to consider:  

1. It evens out the market’s ups and downs: Pound-cost averaging can help balance 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.  

2. You keep 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.  

3. You build 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. 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, which has proven to be the case over the long-term, lump sum investing is likely to 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 more even performance and give you 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 volatile?

Whether you decide to invest a lump sum, make regular contributions or combine both approaches, the key is to stick to your plan, even when the markets are volatile.

Stock market ups and downs are a natural part of investing. And history shows that, over long periods, shares rise in value and deliver better returns than cash.

Find out more about navigating the market’s ups and downs and how to set up a regular payment for 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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