In the previous article, you’ve learned how the Cost Averaging method of investing provides a built-in profit and that it turns every investor into an automatic genius.
We’re expounding the idea further and actually take a look at its advantages, disadvantages and how it fares when the stock market moves up, down or just steady.
So enough talk, let’s get to the meat.
Cost Averaging in a Declining Market
The table above shows a very extreme condition of a Down Market where the share price went from P 25.00 down to P 5.00. Now who would not panic in that situation?
Now, don’t panic yet, this is just an example. I want you to focus on figures at the bottom-right corner of the table above. P 15.00 (yellow) vs P 10.95 (white) – Can you see that?
The wonder of Cost Averaging in a down market is this: It forces you to buy more shares at their cheapest price point.
In the example above, your P 10,000 investment buys you 400 shares in the first month; while in the 5th month when the price is down to P 5.00 / share, the same amount of investment money buys you 2,000 shares.
So think of it this way: In a down market, cost averaging lets you buy at discounted price and therefore you acquire more shares!
Cost Averaging In A Rising Market
Okay, rising market this time. Same amount of investment of P 10,000 per month over a 5-month period. Share price goes from a low of P 5.00 up to P 25.00. Your average cost in this case is P 10.56 per share.
In a rising market, you get fewer shares as the price trends upward, thereby limiting your market exposure.
In other words, since everyone is already paying an over-priced shares, Cost Averaging turns you into a genius and says, “Opps, don’t buy more. The price is already expensive.”
That’s built-in discipline!
Cost Averaging In A Steady Market
A Steady Market is something where the price doesn’t move much. You would say, it’s kind of boring and it is.
Again, take a look at the bottom-right figures above. P 13.20 vs P 13.04. There’s not much difference in there, right?
What’s the moral lesson here?
It’s this: Cost Averaging doesn’t make sense when applied to investments that are non-volatile such as Bonds, Treasury Bills, Time Deposits or even your regular bank deposits.
As you have already seen from the illustrations above, Cost Averaging can actually be used as a tool to minimize your risk exposure and optimize your investment. If it is not yet so obvious to you, here are the advantages and disadvantages of this approach to investing.
The Advantages of Cost Averaging
- It encourages a disciplined approach to investing.
- It allows you to resist the temptation to take short-term gains in a rising market.
- It reminds you to remain calm and not succumb to panic selling in declining markets.
The Disadvantages Of Cost Averaging
- It’s so simple it won’t make you the most popular investor among your friends.
- It doesn’t tell you when to sell like some stockbrokers would.
- It also doesn’t tell you when to buy, but rather it encourages a systematic buying process.
3 Tips – How To Effectively Apply Cost Averaging In Your Investment
Note: The tips provided below are excerpted from authoritative sources, actually published books by well known authors in the field of Personal Finance and Investing. Plus, I also leave my own notes to emphasize some important lessons that you should take with you.
(Note: What follows is an exclusive content available only to PeraTree.com clients under the following categories: VIP Silver, VIP Gold and VIP Platinum.)