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Cost Averaging vs Value Averaging: Pros and Cons

Cost Averaging vs Value Averaging: Pros and Cons

Most stock market investors today do have a day job that may not be directly related to the equity market. Some of us are engineers, doctors, accountants, fastfood chain crew members, seafarers, nurses, etc. As we go on dedicating a reasonable amount of money into investing for our future, we are always trying to seek the formula to success. And we do so by exploring several investing and trading strategies.

In this particular article, let’s get to know one of most common investment strategy called cost averaging, and another counterpart which is value averaging.

Side note: Attend our first run of Technical Analysis Course by TradingOps.com this 2016! Happening on two whole Saturdays March 12 and 19, register for only 4k before March 11! Regular rate is Php5,000. To find out more, please check out link here.

What is Cost Averaging?

Cost averaging refers to the method of 1) investing fixed amount of money, 2) at regular intervals, 3) regardless of the economic situation or whatever the price of stock is. Also, cost averaging can also be practiced on a mutual fund investment.

http://pesosandsense.com/peso-cost-averaging-explained/

What are the Pros and Cons of Cost Averaging?

  1. You do not need to “time the market.” Here, you follow a set of stocks you wish to buy coming out of a brokers’ recommendation or personal analysis.
  2. You are able to buy more shares when price is low. (That means you could also buy shares when price is high). Hence lower cost when price is lower than the price you originally bought a stock, and can be higher than the price you originally bought a particular stock. Goal is to be able to buy more shares at lower costs over a period of time.
  3. Since most stock recommendations come with BBP (Buy Below Price) meaning you are to buy only when the current price is lower than the BBP, this method is seen to be an easy and hassle-free type of investing method. No need to spend long hours studying financial statements, charts, etc. You just need to buy shares at regular intervals say every month for as long as current price is lower than BBP. For people who do have a day job and cannot monitor stock market movements extensively, this method can work for you.
  4. It’s just like paying a monthly bill. Since you have set a fixed amount of money (though you can apparently change this amount due to sudden circumstances or when a windfall comes), you can budget this along with regular expenses.
  5. For mutual funds, you can conveniently set up an automatic debit arrangement that forces you to save every month without having to diarise in your calendar.
  6. Forced can be this good. Though I personally believe that everyone needs a financial check-up every month, cost averaging enables one to focus on other income generating activities or other personal activities, while having an easy as a breeze way to “save” or “invest.”
  7. For newbies, cost averaging is actually a great start. I think this is probably a less riskier way to start investing in stocks, since you do not blindly invest a lump sum amount of money in a stock, but you actually distribute your money into select stocks, across a certain period. As a newbie, your risks are cushioned by investing little amounts of money over a period of say months, and by doing so you possibly buy at lower prices.
  8. Great for longterm as you are in for a long haul.
  9. As Investopedia.com puts it, if a stock price continues to decline, losses are magnified. So instead of cutting loss or exiting from a stock, some would wait and hope that things would turn to their favor. Averaging down to a losing stock is looking at money going down the drain. Here you need the concept of a CLP (Cut Loss Price) which is the price at which you let it go.
  10. As you continue to average down, you might soon end up with a higher than desired weighting of stocks. As Investopedia.com puts it again, say you have a stock from banking and finance industry. As you average down, you now have more shares from this stock relative to other stocks of other industry if the price of this banking stock moves down sharper than the rest. For people who want a certain mix of stocks depending on their personal choice, averaging down would be a major consideration.

What is Value Averaging?

Value averaging takes its roots from cost averaging, only a bit modified. Here, you buy more shares when prices are lower and buy fewer shares (you can even buy no shares at all) when prices are high. The traditional cost averaging tells you to invest fixed amount of money, with no regard to how high or how low the stock market index has hit. Whereas in this strategy, you actually take advantage of low prices.

What are the Pros and Cons of Value Averaging?

  1. You buy more shares when prices are lower than the original price you bought the stock. In effect, you intelligently did cost averaging at a better time.
  2. Makes a lot of sense to know the market too. Is the price of BDO today too high? Is’t a good time to average down? Do I have extra money to buy some more MEG? Traditional cost averaging would spoil investors to thinking that investing is very, very easy and that no need to read through the newspapers and check out what’s happening. Value averaging encourages investors to check out business section of the newspaper and run through the listing of stock prices.
  3. Value averaging somehow takes out the essence of running investing on auto-pilot, since you somehow “time the market.” You need to know when prices are lower and when prices are higher.
  4. Points #9 and #10 above may actually apply also to this kind of strategy, as averaging down has several implications.
  5. Thanks to stock recommendations today and availability of stock market seminars, people are now much aware of setting price targets and meeting it. The thing about this strategy is actually knowing when price is low and when price is high as these concepts may be relative.

Bottomline

Here are my little pieces of advice on these investing strategies:

  1. Stick to what works for you. It may work for you, and may not work for me. It may work today, and may not work tomorrow. Create contingencies!
  2. If you’re feeling a little adventurous and you want to try out a certain strategy, then make sure you have set aside enough emergency fund before plunging into a never-before-tried investing method.
  3. Know more before plunging into a method. Research, ask around, read books.
  4. Always, always, always have a plan. 
  5. If you have the courage the click the buy button, then be humble too to let it go when it’s hurting your portfolio. It is a brave decision, but investing mistakes will make you bolder, smarter, richer.

Happy strategy-thinking!

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