Stock market and mutual funds investors who have been investing for a number of months or years are already aware that the market can only move in three ways:
- Up — which gets them excited
- Down — which makes them nervous
- Level — which bores them to death
But take note: no single person, not even the self-branded expert, can consistently predict which direction the market is moving.
And did you know that there is a method of investing that, when applied to a certain type of security and implemented consistenly, always works in your favor no matter which direction the market moves?
Ric Edelman hails this technique as a way of turning investors (both beginners and advanced) into automatic Investment Geniuses!
I simply call this technique as Cost Averaging, but investors from different parts of the world have their own versions of the name.
In the US, they call this technique Dollar Cost Averaging; British people refer to it as Pound Cost Averaging; and in the Philippines, it should not come as a surprise when our local Investment Press in the Philippines use the term Peso Cost Averaging.
No matter how you call it, what this investment method boils down to is this: you set aside a specific amount of money to invest at regular intervals over a period of time.
Very simple. I know what you’re thinking…Boring!
Studies have validated that Stock Fund and ETF investors who used this strategy have better results than other investors who try to time the market — anticipating the lowest price while feeling nervous at the same time — when buying shares.
Why not? This techniques provides you with a built-in profit if you consistently adhere to the practice over a certain period of time.
Really, A Built-In Profit? How?
Okay, let me illustrate the concept of built-in profit by showing you an example. Say, you’re setting aside P 10,000 per month in your stock (also called equity) mutual fund. Over the course of two months, this is the result:
Share Price = P 25.00
Shares Acquired = 400 ( equal to: P 10,000.00 / P 25.00)
Share Price = P 15.00 (Oh, the market went down!)
Shares Acquired = 667 ( equal to: P 10,000.00 / P 15.00 )
Here is how the hypothetical investment looks in tabular format.
Question: Given the above scenario, what then is the average price of all your shares?
Answer Number 1: Most of you would say P 20.00 per share, because ( P25.00 + P 15.00 ) / 2 = P 20.00.
Answer Number 2: The more correct answer is P 18.74 per share, which is derived from the result of this operation: (P 20,000 / 1,067 shares).
The first calculation gives you the Arithmetic Mean, while the second one gives you the Harmonic Mean.
(Didn’t your Grade School teacher already tell you that?)
Actually, both methods of getting the average are correct, but using Harmonic Mean is more appropriate in this case. While arithmetic mean gives you the average price, harmonic mean gives you the average cost.
And, get this: harmonic mean always results to a lower value compared to arithmetic mean. This is the reason why doing (Dollar/Peso/Pound) Cost Averaging, when done correctly, provides for a built-in profit!
I hope that example already makes sense to you.
But we’ve just scratched the surface of this topic on Cost Averaging. In the next article, I’m going to demonstrate to you — by way of more examples — why this technique really makes sense in good times, in bad times and in boring times such as the upcoming Presidential Election in 2016.
So stay tuned for that!