The stock market is full of frequent ups and downs. But still the basic principle remains the same. The key to successfully trading the stock market can be summarized into 4 words. Buy Low, Sell High. Often easier said than done. How are we supposed to know when we are buying at the bottom or low enough? and how are we supposed to know when we are selling high enough?
That is the beauty of cost averaging, it doesn’t matter. Like many investors, when I first started my journey I did not understand the value of cost averaging. It took me many losses to understand how cost averaging could help me build my portfolio. Buying stocks at reasonable prices over extended periods of time.
- What is cost averaging?
- How Cost Averaging Works:
- Benefits of Cost Averaging:
- Cons of Cost Averaging:
- Summary
What is cost averaging?
Cost averaging is the art of investing small amounts, and very frequently. Or put in a more technical way, investing the same dollar amount on a regular basis, regardless of share price. As a result of this, more shares will be purchased when the price is low, and less shares purchased when the price is high.
The result of this is a lower average cost per share over time. Mitigating the affect market volatility has on your portfolio. Cost averaging is a great way to become a disciplined and efficient investor.
Lets say you want to invest £1000. But you choose to do so at a time that the market is up. You receive less shares for your money due to the high cost per share. Meaning that when the shares fall you will lose more of your investment due to your high average purchase price. Lets see a breakdown of exactly how it works.
How Cost Averaging Works:
Let’s say that instead of investing your full £1000 in one go, you decide to invest it over 5 months. Investing £200 a month into a stock.
| Timing | Amount | Share Cost | Shares Purchased |
| Month 1 | £200 | £10 | 20 |
| Month 2 | £200 | £5 | 40 |
| Month 3 | £200 | £20 | 10 |
| Month 4 | £200 | £5 | 40 |
| Month 5 | £200 | £10 | 20 |
At the end of the 5 months we own a total of 130 shares. Invested at an average cost of £7.70 per share. How would this have looked if we didn’t cost average?
| Timing | Amount | Share Cost | Shares Purchased |
| Month 1 | £1000 | £10 | 100 |
| Month 2 | £0 | £5 | 0 |
| Month 3 | £0 | £20 | 0 |
| Month 4 | £0 | £5 | 0 |
| Month 5 | £0 | £10 | 0 |
In this scenario we invested our entire £1000 when the share cost was still £10. Giving us 100 shares, at an average cost per share of £10. An average share price £2.70 more than in our cost averaged scenario.
In our first scenario our average cost per share was over 20% cheaper. Simply because we spread our payments out over a few months. As you can see, by investing consistently even when the price fluctuated significantly. The average cost per share was lower using cost averaging.
Benefits of Cost Averaging:
Reduced Impact of Volatility
Many people try to time the market perfectly. Buying in at the bottom of a dip and selling perfectly at the peak of a bounce. In reality, this often doesn’t work the way many people think. It is often difficult to tell exactly where the bottom and top of a stocks price is when it is happening. Many people have lost a lot of their money attempting to time the markets this way and getting it wrong.
Cost averaging helps ensure you will have purchased shares at the right times. Keeping your average purchase prices low. While not guaranteeing a profit, it helps to mitigate risk and increase the probability of positive returns.
Disciplined Investing
Cost averaging encourages taking a disciplined approach to investing by setting a regular investment schedule. This helps beginner investors to avoid making emotional decisions in their portfolio. A mistake all too many new traders make. Emotional mistakes like panic selling during a market down turn, or greed selling when it increases kill profits all too often.
Utilizing automatic investments can enhance this discipline. Taking the decision making out of the equation. Having money automatically invested on pay-day or a day of your choice.
Easier to Get Started
Cost averaging makes investing more accessible when getting started. Allowing you to start with smaller amounts of money and gradually increase your investment over time. This is particularly helpful when you are starting investing. Helping you build good habits and strategy without putting a large amount of capital at risk.
Cons of Cost Averaging:
Long-Term Perspective
Cost averaging is a strategy for long term investors. Implementing the strategy can take a long time due to the extended amount of time between investments. Over a shorter time scale cost averaging is not as effective and may even be a hindrance.
Investment Selection
While cost averaging will help you decide WHEN to buy. It wont necessarily help you decide WHAT to buy. You will still need to do your own research and decide what stocks you want to purchase. It is crucial to select assets with long term growth potential to ensure profit.
Transaction Fees
As cost averaging requires making multiple transactions. Fees with certain brokerages may be increased when charged per transaction. While these fees are usually minimal, it is a good habit to keep on top of them. Making sure that they are not eating away at your profit.
Summary
In summary, cost averaging is vital for any long term investing. It can help ensure you get the best average price for stocks of your choice. Ensuring your purchases are not largely influenced by market instability and fluctuation. It helps build good investing practice and help you on your path to becoming a disciplined investor. Discipline is a vital skill of any successful investor on their path to financial freedom. The value of discipline can not be understated. Making cost averaging a vital strategy in the Effortless Investors toolbox.
What are your thoughts on cost averaging? Is it a strategy you already use in your portfolio?
Effortless Investing 
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