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

How investors divide their money between shares, cash, fixed interest securities or property is crucial. 

A common mistake investors make is not diversifying enough: as a result, some have been burnt by having all their eggs in one basket – in other words, all their money in one asset class.

To make sure a portfolio is spread across asset classes, it could contain a blend of equities, bonds, cash, property and others, such as commodities and gold, to benefit from their different investment cycles.

What are the different types of investment?

While diversification is indeed the key to the managing of risk, it’s not just about having a balanced portfolio. Much of the success of investing is down to timing.

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Timing is everything

Timing the market is one of the hardest parts of a professional fund manager’s job, so for private investors to attempt this is an even taller order.

The time an investment is made – that is, when you “buy” into the market, can have a big impact. 

If you choose to invest right before a certain area takes a hit, you could see the value of your savings drop overnight. It all depends on the share price of all the different stocks you are investing in.

Read Annie Shaw's guide to common investment mistakes.

Drip-feeding your investments

A much favoured trick by experts is drip-feeding your money into the market, which removes the need to get the timing right. 

By saving a monthly amount into your investment portfolio you can cash in regardless of how the market is performing. 

Find out more about investment risk.

It smooths out the highs and lows in share prices. When they go up, the value of your stocks rise, and when they go down your next contribution buys more. 

This is known as “pound-cost averaging”. Plus, buying stocks at a lower price means you get a higher return when the market swings back up.

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How does pound-cost averaging work?

For example, if you decided to invest £100 a month, in that first month, the share price of your chosen stock is £5, so you can buy 20 shares. Should the share price fall to £4 the next month, you will buy 25 shares, leaving you with 45 shares.

If you had initially spent a lump sum of £200 on the shares, you would now have just 40 shares. In a volatile market, the average price per share can work out lower when you save regularly - in this case the price per share is £4.44 against £5.

This means that regular investing is a prudent approach even for those with a lump sum to invest, from a bonus or inheritance perhaps, who could divide the sum into 12 equal amounts and drip-feed the money in monthly.

Read Annie Shaw's guide to investing online.

Of course it’s by no means a fool-proof plan. While it is true that regular investing can smooth the effects of downward share price movements, it can also work against you when markets are climbing. 

For example, if you had invested £200 to see the £5 share price double over the next month, you would have 40 shares now worth £10 each, and a total of £400.

By contrast, a regular investor's £100 monthly contribution would have bought 20 shares at £5 in the first month but only 10 at £10 in the following month, a total of 30 shares worth £300.

Drip feeding money into the market avoids the stress of risking the whole sum or the regret you might feel if markets fall, incremental investment may suit you better.

How can you trace old shares?

Coping with a volatile market

Although falling markets will reduce the value of existing holdings, savers who invest regularly have the compensation of knowing they will be buying more, at a cheaper price, with their new money.

Yet savers with money invested in equities will naturally worry because it means the value of their investment is falling. It’s important to remember that fluctuations are part and parcel of investing, and any losses to capital are only realised if you pull your money out. As things stand the losses are on paper.

It can be difficult to take a long-term perspective during volatile markets.

Read our guide to reviewing your investments.

Experts unite in the opinion that investors can get too involved with day-to-day movements and how funds are performing, worrying over the latest share price shift or market panic.

While it is important to monitor how your portfolio is performing, the point of buying funds is to let the professionals worry about market movements.

While such times can be alarming, experts recommend ignoring short-term noise and making sure you stick to your long-term investment strategy and goals.

Regular investors develop the habit of investing money each month regardless of market conditions.

It is a good discipline to have a standing order set up to go out of your account every month because then you get into the saving mindset.

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Every little helps

With even a seemingly small contribution each month, the cash can soon mount up and over the long-term can grow to a decent sized fund. Especially if using tax efficient investments, such as an ISA.

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