‘Insurance against regret’ – Investing your inheritance with pound-cost averaging
Pension: Jordan Gillies share tips on planning and investing
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As an “insurance against regret” strategy, pound-cost averaging is the idea of making regular contributions to investments as a means of addressing the volatility of the market.
Through making regular contributions, investors end up purchasing fewer units when prices are high and more units when prices are low.
Therefore when someone receives a large amount of money, either through an inheritance or business sale, they may choose to spread this money out when investing it.
This is where pound-cost averaging can be used, however many experts do point out its costs.
Pound-cost averaging provides some protection against the possibility of the market dropping dramatically shortly after money is invested.
In lieu of the whole investment suffering from a loss, only the invested amount is affected by such a crisis.
Comparatively, the remaining amount is left then invested at lower prices. In this case, pound-cost averaging is known for working well in falling markets.
Yet, due to markets usually going up instead of down, this investing strategy often results in investors buying when prices are increasing instead of declining.
Speaking exclusively to Express.co.uk, Zoe Dagless, Senior Financial Planner at Vanguard, outlined the pros and cons of pound-cost averaging.
She said: “At some point in your life you may receive a large sum of money in the form of an inheritance.
“If you’re planning to invest this inheritance you will probably face a dilemma: do I invest it all at once or do I drip it into the market in instalments over time?
“This approach is known as ‘pound-cost averaging.”
“But it’s important to know this approach can come with a cost. What often tempts investors to use this approach is the fact that pound-cost averaging could provide some protection against the possibility of the market dropping sharply shortly after the money is invested.
“No one wants to accidentally buy at the top of the market. So instead of the entire investment suffering this loss, only the smaller invested portion does.
“Then in theory, the remainder is then invested at lower prices. In this way, if the market was falling, pound-cost averaging would work well.”
She explained markets often tend to go up more often than down, which could impact decision making.
Ms Dagless continued: “This means that with pound-cost averaging you’d be more often likely buying when prices are increasing rather than declining, which would be an inefficient strategy.
“Another drawback to pound-cost averaging is that it will alter the asset allocation of your existing portfolio until the new amount is fully invested. So any extra cash you hold could skew your overall mix of investments and make it different to what you’d originally planned.
“However, pound-cost averaging can be a perfectly valid strategy for some because it can provide insurance against regret – nobody likes the idea of investing a significant sum of money, only to see the market drop immediately afterwards.
“But most of the time, pound-cost averaging will lead to lower long-term returns, meaning investors would have been better off investing their funds all at once. Remember, it’s all about time in the market rather than trying to time the market that counts.”
The financial planning expert also emphasised pound-cost averaging is only relevant to investing big sums of money, or a large inheritance, as opposed to regular everyday investments.
She explained: “It’s important to note that the pros and cons of pound-cost averaging are only relevant when discussing investing large lump sums of money and shouldn’t be confused with the regular investments you might make out of your salary with an ISA or SIPP.
“These do also help you get invested at different prices and in that sense help average out the overall price at which you get into the market. But they are each lump-sum investments in their own right because you make them immediately as you get paid.”
Those who are making investment decisions are always encouraged to think carefully, and take advice if required.
With investments, a person may get less than they originally put in, and so should be aware of this risk.
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