August 30, 2014

Monthly investing Vs Lump sum investing

Newcomers to investing commonly ask whether monthly investing is better than lump sum investing. And the answer to the question is monthly investing can provide numerous advantages as discussed below.

Pound cost averaging, the benefit of monthly investing

The main benefit derived through monthly investing is simply known as ‘pound cost averaging’. This refers to the concept of volatility in the markets allowing your investment to purchase a greater amount of shares. For example, imagine the markets have fallen, monthly investments will allow you to buy more shares than if you had made one big lump investment. This is because you can purchase more shares at a lower price.

If more shares are acquired when the price is low, and fewer than when the price is high, this can equate to you gaining a larger amount of shares overall in comparison to one lump sum investment.

This is highlighted with the following easy to understand example:

Assume you invest £100 over three months (for the basis of this example only, investments should be at least 5-10 years ideally):

Month 1 share price: 100p, your £100 will allow you to purchase 100 shares at 100p.

Month 2 share price: the share price falls to 75p, your £100 will allow you to buy 133 shares, which is more than 100 you got in the previous month.

Month 3 share price: the share price rises to 110p, your £100 will now only allow get you 90.9 shares, which is down from the last month.

However, overall pound cost averaging has worked to your advantage because you have managed to acquire 324 shares for £300 over the three months. If you provided a £300 lump sum payment in month 1, you would have received 300 shares only.

Other benefits of lump sum investing

Besides the potential benefits of pound cost averaging, monthly investing has the potential to provide a smoother return and reduce your risk as markets can be volatile. For example, imagine you invested £10,000 just before a market recession. Your investment would be worth much less. However, if you invested £100 a month, you would be subject to far less risk. Similarly, you can ensure that you buy more units when the price is lower, and less units when the price is higher.