What Is Cost Averaging A Simple Guide for Smarter Stock and Index Investing
You're at the store, witnessing the price of avocados rise and fall. One week they are $2 each, and another month, they are $4, etc. You could try to determine when the price would be its lowest, but you simply purchase two avocados every week, regardless of price. Eventually, you will have acquired an average price that is reasonable without the stress of determining the best time to buy.
Cost averaging, or dollar-cost averaging, is a kind of investment strategy that involves consistently investing a consistent amount of money into stocks, indexes, or any kind of asset, at regular intervals and time intervals. It does not matter what the price is. It does not matter if the market is in an uptrend or downtrend. You simply invest $500 every month (or $100 every week, or whatever amount works for you) like you are clocking in for your job.
Understanding the Core Concept of Cost Averaging
So what happened? After three months, the stock price ended at $40 (lower than it was at your initial purchase). However, your average cost ended up even lower than that. The stock price decrease in the second month helped your average cost, because your fixed amount of $300 allowed you to buy more shares.
Let’s compare this to a lump sum investment scenario where you invested $900 all at once. If you purchased shares on the first day at a price of $50/share, you would own 18 shares at a cost of $50/share. The average cost for your cost averaging scenario was lower and you were able to purchase 5.5 more shares.
Advantages of Cost Averaging: Building Stability in a Volatile Market
It removes emotional decision making from the equation. Email and greed can destroy a portfolio. When the market is crashing, fear yells "sell everything!" When the market is soaring, greed will whisper "buy even more now!" Cost averaging ignores both. You invest consistently, whether the market is up/down 10%. I think most investors do not realize how valuable the emotional discipline of using cost averaging really is in the grand scheme of things.
Volatility is less frightening. In fact, it can even be somewhat advantageous. When the market dips, you do not panic; instead, you know that your next purchase will allow you to purchase even more shares, as you are now buying at a lower price. Just like that, you begin to think of corrections as sales rather than disaster. This change in your mindset will keep you invested in a stock during a period when everyone is selling at the worst possible time.
Limitations and Misconceptions: When Cost Averaging May Not Work
Let's be clear on what cost averaging can't do: it is not a profit guarantee; it is a risk management strategy. In consistently rising markets, lump-sum investing usually wins. If you ever knew (somehow) that a stock or index was going to steadily rise in price, you would want all of your money invested immediately so that you could capture the entire rally. Cost averaging means you are holding cash to invest, and you would miss out on that early profit. Based on historical data on major indexes, lump-sum investing has typically outperformed cost averaging in about two-thirds of the rolling periods based solely on the fact that the markets tend to rise more than they fall.
Consistency Is the Real Edge
The strategy is not without flaws. In consistently rising markets, having long-term cash invested sooner will outperform buying over time. The strategy manages timing risk rather than fundamental market risk - you can still lose money if you are wrong about where to invest long term. Cost averaging also requires the patience (as opposed to sudden commitment) and time to keep investing on a regular basis even in uncomfortable periods.
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