It’s possible that you may receive a large sum of money at some point in your life. Your savings or investments might have matured or you might have sold a business or asset such as a house. Perhaps it is an inheritance or severance package – or, who knows, maybe you’ve got lucky with your favourite numbers and won the Euromillions.
If your goal is to invest this money into the market, then you need to consider two options: to invest it all at once or to drip it into the market over a period of time?
For many investors, spreading out the investment is the preferred option. By averaging out the levels at which they invest in the market, they avoid buying at a single price.
Pound cost averaging is an investment strategy that uses this approach to make investments. But it is not without risk.
With pound-cost averaging, investors are protected against the risk of sharp drops in the market after investing their money. Everyone wants to avoid accidentally buying at a market peak.
As a result, only the invested portion of the investment suffers this loss. The remainder can therefore be reinvested at a lower price. This way, pound-cost averaging can be effective in a downturn.
The problem is, though, that historically markets tend to rise more often than they fall – in fact, almost two out of every three months since the FTSE All-World Index was launched at the end of 1993, global shares have finished higher than the previous month. If you use pound-cost averaging, you are more likely to buy when prices are going up instead of going down, which would be a waste of potential returns.
Obligatory finance website note: Past performance is not a reliable indicator of future results
Unexpected portfolio allocation
Another problem with pound-cost averaging is that it changes your existing portfolio’s asset allocation until you have invested the new amounts. In other words, if you hold extra cash, it can deviate from your initial investment plan and may affect how your overall investments are mixed.
Consider a portfolio that was structured with 70% shares and 30% bonds – suddenly, holding a lump sum of the same size flips that structure to a 35% share, 15% bond, and 50% cash allocation dramatically altering your portfolio’s investment position and strategy.
This would be a very different allocation – one that would not be in line with your goals and lower your chances of investment success, given research demonstrating how important asset allocation is to investment success.
Cash earns a meagre return, which will drag on the performance of your portfolio. A cash drag on returns can persist indefinitely if funds are never fully invested – perhaps because you forget about them or are unnerved by a market decline.
Is pound-cost averaging a bad idea?
Then if there is a cost to the strategy, is there any value whatsoever to pound-cost averaging? For some investors, yes. You can use it as a valid strategy if you want to protect yourself against regret or simply don’t have the lump sum of funds ready to go.
Investments made in the stock market, only to see it plummet immediately afterwards, is never a pleasant experience. This fear of regret prevents some investors from investing at all. Instead, they decide to wait until they feel more confident about the market before investing but the market may never meet their expectations.
This can help these beginner investors overcome their paralysis and at least bring some money into the market, by pound-cost averaging.
Of course, this hedging against regret doesn’t come cheap. It is generally more advantageous to invest all funds at once rather than pound-cost averaging, since it results in lower long-term returns. In the event of a downturn, pound-cost averaging might at least provide a buffer against regret – especially if the alternative is to not invest in any way.