Cost Averaging Effect
The fluctuations in market prices often tempt investors to wait for the perfect moment to buy assets. Others hesitate to invest because they fear entering just before the next market crash.
However, trying to time the market perfectly—by buying at the lowest price and selling at the highest—is difficult, if not impossible, because no one can predict market movements or the price of a single stock with certainty. To reduce the risk of investing at the wrong time, investors can take advantage of the cost averaging effect.
The cost averaging effect occurs when regular investments are made into assets like stocks, ETFs, or funds, with the same amount being invested repeatedly. Over time, this results in an average entry price, which smooths out market fluctuations.
- The cost averaging effect benefits investors, especially in highly volatile markets and when prices are expected to fall in the medium term.
- However, using this strategy is not always more profitable than a lump sum investment. In fact, lump sum investments often lead to higher returns over the long term, especially when prices are rising long term.
The cost averaging effect explained with example
- Viktor invests 100 CHF every month in a fund. In Month 1, the price per share is 100 CHF, so Viktor buys 1 share.
- In Month 2, the price per share rises to 200 CHF, so Viktor can only buy 0.5 shares for the same 100 CHF.
- In Month 3, the price per share drops to 50 CHF, so Viktor buys 2 shares.
- In Month 4, the price per share is 300 CHF, so Viktor buys 0.33 shares.
- In Month 5, the price per share drops to 50 CHF again, so Viktor buys 2 shares.
- In Month 6, the price per share is 100 CHF, so Viktor buys 1 share.
|
Month |
Investment | Price | Shares bought | Total shares | Total investment | Average purchase price |
|
1 |
100 | 100 | 1 | 1 | 100 |
100 |
| 2 | 100 | 200 | 0.5 | 1.5 | 200 |
133.3333333 |
|
3 |
100 | 50 | 2 | 3.5 | 300 | 85.71428571 |
|
4 |
100 | 300 | 0.333333 | 3.833333333 | 400 |
104.3478261 |
| 5 | 100 | 50 | 2 | 5.833333333 | 500 |
85.71428571 |
| 6 | 100 | 100 | 1 | 6.833333333 | 600 |
87.80487805 |
After 6 months, Viktor owns 6.83 shares in total and has invested 600 CHF. His average purchase price per share is 87.10 CHF.
If he had invested 600 CHF all at once in the first month, he would have only bought 6 shares, and his average cost per share would have been 100 CHF which is higher than the average cost achieved through regular monthly investments.
In Words:
By consistently investing the same amount, Viktor automatically buys fewer shares when prices are higher and more shares when prices are lower. This smooths out the fluctuations in price and minimizes the risk of investing at a poor time.
But be cautious
If prices are steadily rising in the long term, the average entry price also increases. In such a case, a lump sum investment at the beginning would have been more profitable.
Here’s the breakdown for rising prices over 6 months:
|
Month |
Investment | Price | Shares bought | Total shares | Total investment |
Average purchase price |
|
1 |
100 | 100 | 1 | 1 | 100 |
100 |
|
2 |
100 | 200 | 0.5 | 1.5 | 200 |
133.3333333 |
|
3 |
100 | 300 | 0.333333 | 1.833333333 | 300 |
163.6363636 |
|
4 |
100 | 400 | 0.25 | 2.083333333 | 400 |
192 |
|
5 |
100 | 500 | 0.2 | 2.283333333 | 500 |
218.9781022 |
|
6 |
100 | 600 | 0.166667 | 2.45 | 600 |
244.8979592 |
f Viktor had invested the entire 600 CHF at the beginning, he would have purchased 6 shares at an entry price of 100 CHF each, rather than the 244.90 CHF per share he paid with regular investments.
This results in a value difference of 2’130 CHF by Month 6.
*Note: With a lump sum investment, Viktor could have benefitted from higher dividends over time, which is another factor to consider.