One thing that people often don’t consider when investing is how they’re going to deposit into their investment account. There are generally two ways you can do this, either by investing a lump sum or by setting up monthly ongoing payments. You could even combine them both.
Here's everything you need to know...
What is pound cost averaging?
Pound cost averaging is where you make your investments on a regular basis, for example, making a recurring payment every month. You can do this by setting up a monthly direct debit for an affordable amount.
What are the benefits of pound cost averaging?
When using pound cost averaging as your strategy, the price of shares that you purchase are likely to vary each time. This means that you may buy more shares when they’re at a lower price and sometimes shares when they’re at a higher price. This tends to balance and average out over time – hence the name pound cost averaging!
By investing money through pound cost averaging, you're not trying to time the market (investing intentionally when the markets are down to make the most of the low costs). Timing the markets can be difficult as there are a lot of factors you may need to consider and it’s unlikely that you’ll get it right. Pound cost averaging may be a better strategy for inexperienced investors as contributions are spread over a period and no knowledge of the markets is needed. It also means those who want to take less risk avoid seeing a big investment they’ve made immediately fluctuating, which can be unsettling.
What are lump sum payments?
You may already know what “lump sum payments” mean, but if you don’t, we’ll be going through it with you now. Lump sum payments, as suggested in their name, mean you deposit a large amount of money into your investments, all at once. So, if you had £5,000 to invest, you’d invest all that money at the same time.
What are the benefits of lump sum investing?
This payment strategy gives you more control over your money as it gives you the flexibility of making your investment whenever you like. For example, you may want to place a lump sum when the share prices are low, that way if the share price increases you can sell them for a potential profit.
Investing in lump sums are normally for those who may have a high-risk appetite but are keen on earning a greater reward. You should only invest with a lump sum if you are comfortable with the amount of risk involved in your investment.
A lot of people tend to use this method when depositing their annual ISA allowance at the end of the tax year, so they don’t miss out on their allowance.
What's the difference between lump sum and pound cost averaging?
Let’s say you were to invest a lump sum of £10,000 into an ISA account today. Now, imagine the market falls consistently over a 12-month period and so, you’re left with a total of just £9,000*. That means you will have lost 10% of your total lump sum investment and in order to recover your loss, your £9000 will have to grow by over 11%.
Now comparing that with pound cost averaging. With this strategy, you’ll deposit £833.33 each month which equals a total of £10,000 over the year. As the market falls in value, you’ll have less capital invested, so your losses will be lower. As a result, the final value of this investment is £9,474* which means you have £474 more than if you were to invest with a lump sum at the beginning of the year.
This works the other way too. If your investments perform well, you may have been better off with a lump sum payment at the beginning.
* These figures have been calculated with a 0.83% drop in portfolio value every month for a year.
Which strategy is best?
Now that you know about the different types of payment methods that you can use to invest, it’s time to pick the right one for you.
If you have quite a bit of cash ready to invest, a lump sum payment could be right for you. Instead of letting your money slowly lose its value in a bank, it may be better for you to invest into something that could potentially earn you money in the long term.
For those that don’t have cash waiting to invest, you may want to set up a regular payment. Pound cost averaging may be better if you have a steady source of income in which you can invest a certain amount every month. It’s also important to think about how comfortable you are with investment risk. If you are a new investor or you want to take less risk, depositing a regular amount each month could be better.
If you’re considering investing, we can help with personalised financial advice. We’ll tell you whether your contributions are affordable, in both lump sums and ongoing payments. We’ll also recommend a suitable risk portfolio for your current level of investment knowledge and attitude to risk.
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