How Does Cost Averaging Work: Passive Stock Market Investing Part 2

Posted by Fitz Villafuerte under Investing on February 18, 2011

In the previous post, I showed you How To Do Cost Averaging – which is simply investing equal monetary amounts regularly on a particular stock over a period of time.

For Part 2, I shall try to explain how cost averaging actually works.

First, you should know that cost averaging is not limited to the stock market.

You can apply it to any investment – although the stock market is ideal because its prices are more volatile.

Moreover, it is applicable to any currency.

If you search the internet, you’ll find that much of the points discussed in articles about dollar cost averaging, pound cost averaging, or even rupee cost averaging, apply to peso cost averaging as well.

So, with that in mind, let’s now learn how cost averaging works.

The table below uses the same data which I gave in Part 1.

It’s basically the same table except for the last two columns. It now shows the average price of the stocks you own and it’s difference to the “current” price.

The ‘Average Price’ is calculated by dividing the ‘Total Amount Invested’ by the ‘Total ABC Stocks’ you own. While the ‘Difference’ is simply ‘Stock ABC Price’ minus that ‘Average Price’.

Assuming the stock price continues to fluctuate sideways over a longer period of time, then the ‘Average Price’ will approach an almost constant value as shown below:

The important thing to realize in this graph is that – when the trend is going sideways, cost averaging can provide you with opportunities to make acceptable profits.

Imagine if you had P72,000 and used all of it to buy Stock ABC last January 2008, then you would have to wait until the stock price trends up and go beyond P30 to be able to make profit.

But what if you bought it last July 2008, when the stock price was at P10, wouldn’t you be able to make more money in this example?

Yes that’s right – but unless you’re a stock market analyst, it’s almost impossible to say if the current price is at the lower limit or at the upper limit. The example above shows a constant sideways fluctuation – actual stock prices do not move that way.

Cost averaging takes out the need to closely monitor the market and allows you to invest at any time. It’s a passive way to invest so you can focus more on other active ways to make money.

Furthermore, the two graphs below show the behavior of the average price when the stock price is constantly going up and when it’s constantly going down.

Notice that the rate at which your profit margin changes (the vertical space difference between the red line and the blue line) is greater when the stock price is going up than when it is going down.

This means that if a stock whose price has been going up suddenly trends down, you’ll have more time to decide if you should sell your stocks and make a profit before the breakeven price happens.

On the other hand, if a stock that’s been going down, suddenly starts to trend up, you won’t have to wait that long before the stock price overtakes the average price of your stocks.

“But I heard cost averaging is not the best strategy to do when investing…”

Indeed, some financial experts claim that cost averaging does not really reduce one’s exposure to market risks. Others even claim that it’s not a sound investment strategy because it often results to lower overall returns as compared to other strategies.

Personally, I agree that cost averaging does give you less profit than if you did fundamental and technical analysis on the stock market. However, doing that takes time and dedication to learn.

Lastly, I believe that doing cost averaging is better than having no investing strategy at all, which unfortunately is what most people do in the stock market.

This ends Part 2 of this series.

In the next and final part, I shall give you examples of ACTUAL STOCKS and how your investment would have performed if you did cost averaging on them.

More importantly, I shall give you tips on HOW TO PICK the best stocks for cost averaging.

Make sure you don’t miss that by subscribing to Ready To Be Rich.

Don’t know anything about the stock market?

Then visit: How To Invest In the Stock Market.

Easy Series Reference:

Shares

SELECT AN ARTICLE TO READ NEXT BELOW:

12 Responses to “How Does Cost Averaging Work: Passive Stock Market Investing Part 2”

1. […] « How Does Cost Averaging Work: Passive Stock Market Investing Part 2 […]

2. Olan says:

Sir Fitz,

Im a member of Bro. Bo’s TrulyRichClub in which he advises membrs to invest in EIP thru cost averaging method by buying stocks in a monthly basis. Since the system requires me to invest a fixed amount, in a period of 10 years – in my case. When prices of ABC stock went up, is that same amount would still be sufficient to buy the required minimum board lot. For example, ‘is my monthly investment of 2,000 that can buy 100 shares this year,could still buy at least 100 shares 5-10 yrs from now? Or is it being rolled?

Hope you can help me with this.

Thanks & God Bless.
OLAN

3. Fitz says:

Hi Olan,

It’s up to you what you want, if the stock becomes “too expensive”, then you can choose to just skip buying for that period, which is what I would do.

Also, read part 3 of the series, specially the comments there because someone asked a similar question as yours. ๐

4. […] these uncertain times, people who would like to invest can still enter the market by adopting the cost averaging strategy as it is a buyer’s market right […]

5. […] })(); « Money Issues That Couples Should Talk About How Does Cost Averaging Work: Passive Stock Market Investing Part 2 […]

6. Rima Kates says:

Hi. Thanks for sharing this to us who are interested investing into stock market. I’m newbie when it come to this. I really appreciate any help you could give us.Question as follow.1. If I want to invest in a company, for example SMC ( San Miguel Corporation) what should i check first? financial statement of the company, like the Current Assest and Current Liabilities???2. Should I check the current news regarding that company.3. What is INDEX FUND??? where and how can I find that?4. How to pick a good company to invest in? what should I be checking first if I want to invest on that company?

7. Hakiro Killingfield says:

HI FRITZ, CAN U PLEASE WRITE A SHORT ARTICLE ON “DISTRIBUTION OF DIVIDENDS” I AM A BEGINNER IN STOCK INVESTING, I HAVE JUST STARTED RECENTLY AND TILL NOW HAVE NOT EXPERIENCED YET TO RECEIVE A DIVIDENDS (CASH OR STOCKS DIVIDENDS). FOR EXAMPLE IF THE COMPANY DECLARED A 20% STOCK DIVIDENDS OR 0.60 CENTAVOS CASH DIVIDENDS – HOW MUCH EXACTLY I WOULD RECEIVE IF I HAVE 20000 SHARES OF A STOCK WITH CURREN PRICE OF PHP 70.00. PLEASE NEED YOUR HELP. I AM AN OFW AND THERE IS NO ONE NEAR ME WHO CAN ENLIGHTENED ME ON THE SUBJECT. THANKS AND REGARDS.

8. Fitz says:

Hello Hakiro, the dividends should automatically be added to your account on the said payment date – and the computation is very straightforward.

If the company has announced that they will give 20% stock dividends, then that means you will receive 20% more shares of what you currently owe – if it’s 20,000 shares, then it should become 24,000 shares.

If it says you’ll receive 0.60 centavos (or 0.0060) per share as cash dividend, and if you currently have 20,000 shares – then you’ll have 120.00 cash added to your account fund.

9. Marius de Jess says:

Thanks for the explanations.

But I am still waiting to read what you know about how the operators make money from the money we hand over to them to make money for us.

And whether they make money for us or not, they do make money for themselves, just the same.

Just the same, thanks a lot for your explanations.

Marius de Jess

10. Rajon says:

Sir Fitz, may idea po ba kayo paano kinokumpute ang Fair Value (FV) ng COL?
thank you.

11. Bong says:

Sir,

I have a silly question with regards to the previous conversation on dividends.
If I will receive a cash dividends, can I be able to withdraw it in a cummulative period? or unless I sell all my shares?

thanks

12. […] How Does Cost Averaging Work […]