Updated: February 28, 2018
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.
How Cost Averaging Works
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.
Is It The Best Strategy?
“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.
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Don’t know anything about the stock market?
Then visit: How To Invest In the Stock Market.
Easy Series Reference:
- How To Do Cost Averaging: Passive Stock Market Investing Part 1
- How Does Cost Averaging Work: Passive Stock Market Investing Part 2
- How To Pick The Right Stocks For Cost Averaging: Passive Stock Market Investing Part 3
Disclaimer: The information above should not be taken as financial advise. This article is merely for educational purposes.