Money Management and the Economy

Wednesday, April 1, 2009

Why Cost Averaging Really Does Work

You aren't smarter than the market. It really is that simple.

There are a number of places on the internet and in the media where people have questioned the value of "cost averaging". Cost averaging is investing in regular amounts over time, rather than in one lump sum all at once. It has been standard investment advice, but now some critics are arguing that, since the market in the long run tends to go up, the earlier you invest the better. Cost averaging will reduce your return in the long run.

They are, of course right. On average, you will get a lower return. But cost-averaging is not done to maximize returns. Its used to minimize risk. It is a strategy to make sure you get an "average" return instead of hitting just one peak or one valley.

Think about it this way. Suppose someone offered to flip a coin and pay you $51,000 if it was heads, but you would have to pay them $50,000 if it comes up tails. Would you take that bet? On average, you would come out ahead. But only a gambler makes that kind of bet unless you can afford to lose the $50,000. On the other hand, if they offered to flip a coin 1000 times with the same odds, you might be tempted. The odds are still in your favor and you are unlikely to lose every time and cost you $50,000. Of course you are also unlikely to win every time and win $51,000 either. Instead you have a good chance of coming out ahead somewhere between those two exremes.

The market works the same way. If you want to maximize your return you, flip the coin once. If you want to minimize risk you spread your flips out. Most of us are trying to be investors, not gamblers. We want to make a reasonable return while preserving what we have. So lets look how this works in practice.

If you have $5000 to invest in your IRA and invest it on the first of the year you will do better, in the average year, than if you put $100 into your IRA over the course of the year. The problem is that not all years are average. More importantly, not all starting points are average. Some years the value of stocks will be higher to start the year than the average over the course of the year, other times it will be lower than average. In fact, in the current market, that is true from week to week as you can see in the example below.

This year I decided to basically add $100 each week to my IRA. The details are a bit more complicated than that, but I am simplifying here. So what do those investments look like:

Date Shares Security $Invested

1/6/2009 5.893 Vanguard Balanced Index Fund Investor Shares $100 
1/13/2009 6.127 Vanguard Balanced Index Fund Investor Shares $100 
1/20/2009 6.427 Vanguard Balanced Index Fund Investor Shares $100 
1/27/2009 6.250 Vanguard Balanced Index Fund Investor Shares $100 
2/3/2009 6.301 Vanguard Balanced Index Fund Investor Shares $100 
2/10/2009 6.329 Vanguard Balanced Index Fund Investor Shares $100 
2/17/2009 6.489 Vanguard Balanced Index Fund Investor Shares $100 
2/24/2009 6.588 Vanguard Balanced Index Fund Investor Shares $100 
3/3/2009 7.018 Vanguard Balanced Index Fund Investor Shares $100 
3/10/2009 6.887 Vanguard Balanced Index Fund Investor Shares $100 
3/17/2009 6.562 Vanguard Balanced Index Fund Investor Shares $100 
3/24/2009 6.394 Vanguard Balanced Index Fund Investor Shares $100 
3/31/2009 6.460 Vanguard Balanced Index Fund Investor Shares $100 

You will notice that the first shares I bought were also the most expensive. Had I invested to my IRA limit to start the year, I would likely end the year with many fewer shares than I will by my strategy of cost averaging. In January and February, I came out ahead with lower prices later in the month. In March, I would have been better off to purchase on March 3rd, when prices hit bottom for the year so far.

That is true, even if stock prices eventually recover to the level they were in January. The only way I will come out behind is if the average price I pay over the course of the year is higher than it would have been in January. Otherwise I will end the year with more shares of stock, regardless of their price at the end of the year. If 20 years from now, I sell the shares from these transactions, I am going to get 20% more money for the shares I purchased on March 3rd than I will for the shares I purchased on January 6th. That is a pretty significant difference.

I am looking only at share prices here. But there is another factor to consider in evaluating the overall return. That is any dividend payments I receive. Because my IRA is not getting dividends on shares I don't yet own.  Of course, the dividends in the future will also be higher since I own more stock. 

Which just clarifies when cost averaging makes sense. If you are buying investments where the primary return is from dividends and/or interest, you probably don't need a risk limiting strategy like cash averaging. But if you are buying securities whose price is volatile, cost averaging will reduce your risk and sometimes save you from paying a premium price that you will never recover.

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