‘Pound cost averaging’ is the idea that if you spread your investment purchases over time you might be able to improve your average entry cost – and, as a result, boost your potential returns.
Does it work? Sometimes yes, often no.
It depends on how markets behave, which is something no-one can ever predict with certainty.
During a crisis, pound-cost averaging can perform better than investing a lump sum straightaway since, on average, you are likely to be buying more fund units as prices fall – until markets, in theory, start to recover.
But when markets are rising, an immediate lump-sum investment approach is clearly better since you are getting in at a lower price.
And if history is any guide, there tend to be more up months than down months – quite a lot more, as the diagram below shows.
Up versus down
Source: Vanguard calculations using data from Morningstar. Stock market represented by the FTSE All-World Index in total return, GBP terms from 31 December 1993 to 31 May 2021. Note: Past performance is not a reliable indicator of future results.
It’s why, if you find yourself with a large cash lump sum, it can make more sense to invest it all at once rather than stringing it out over many months.
As I explain in this previous article, it’s time in the market not market timing that matters most in the long run.
Investment zen and discipline
However, all that is inconsequential if you are investing as part of a regular savings plan, via direct debit, since you are already pound-cost averaging with each monthly investment.
Aside from the calm and convenience that comes with delegating your decision-making to an automated bank transaction, and the self-discipline it affords, it’s also consoling to know when markets are weak that you are getting in at a better price each time.
For illustrative purposes, consider these two charts pitting the hypothetical performance of a lump-sum investment of £2,400 (green) over two years against that of 24 £100 monthly investments (yellow) under two different imaginary scenarios.
In the positive hypothetical environment, where the market rallies by 20% over the period, it is the lump-sum approach that wins. In the more negative scenario, in which it falls by 20%, it’s the other way around.
Past performance is not a reliable indicator of future results.
Source: Vanguard calculations using data from Bloomberg. Stock market represented by the FTSE All-World Index in total return, GBP terms from 31 December 1993 to 31 May 2022.
We can’t guarantee that pound-cost averaging is the best investment strategy to follow because we don’t have a crystal ball to see into the future. In fact, the evidence suggests that investing a lump-sum is the better policy.
However, during volatile and uncertain times like these, pound cost averaging can be a successful strategy.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
Other important information
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Issued by Vanguard Asset Management, Limited which is authorised and regulated in the UK by the Financial Conduct Authority.
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