The Law of Averages

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Figuring out a broad strategy for equity investing can sometimes be as difficult as deciding what specific stocks to buy. Investors who are wary of getting in "at the top" are often troubled not only about when to enter into the stock market. They also worry about how much of their savings they should commit at any given point. One method that takes these concerns into account is cost averaging, which some financial advisers promote as an ideal strategy for those who want to invest in equities but can't quite shake the feeling that fools rush in where cautious investors fear to tread.

Cost averaging--usually known as dollar, or pound, cost averaging although the term applies to any currency--is a fairly straightforward concept. Investors select a particular stock or a mutual fund and invest a predetermined amount at regular intervals, come what may. Investment advisers in favor of cost averaging say it builds good investment habits and ensures that investors are not risking too high a proportion of their capital at any one time. Critics note, however, that cost averaging should be limited to certain types of investments, and that in some circumstances it is an over-cautious approach that may deprive investors of returns.

But cost averaging eases investors' legitimate fear of venturing into equities when prices are at a peak--and then watching in horror as they plummet. By its nature, cost averaging means that uncertain investors don't need to worry about "timing" their entry into the market. "Those decisions can be especially difficult for private investors," says Jason Hollands, deputy managing director of financial advisers Best Investments. With cost averaging, he says, "there's a steady program of buying--investors can put in tranches on a regular basis." Consider a stock or fund into which an investor places $500 a month at an initial price of $25 a unit or share. After one month, the price moves to $30, the next month to $20, then $15, $10, and then back to $20 (see graph). Without doubt, the price after six months is less than when the investor started. But the overall accumulation is 170 units or shares at an average price of $17.65, and that's the essence of cost averaging--investors buy fewer shares when the price is high, and more when it falls. "Even if there are sharp movements in the market," says Hollands, "they're still effectively getting the average price."

In spite of these positive aspects, advisers argue that cost averaging is not applicable to every type of market--or indeed for every type of asset. "It's less relevant for something like bonds," says Justin Modray, an adviser at Chase de Vere, "because bonds and fixed income assets tend to be far less volatile." Indeed, volatility can be the key to success: as equity cost averagers tend to benefit from wild market movements, the strategy generally better lends itself to areas such as emerging markets or sectors like technology. "It evens out market movements," says Modray, "and can mitigate the worries associated with volatility."

It is important, however, that investors take their time horizons into account when considering cost averaging. In general, investment strategists recommend that equity investors sit tight for at least five years--a period which might neutralize any cost averaging benefits. "Historically, figures show that investors might have done better if they had simply put the entire sum into the market up-front," says James Dalby, a researcher at financial advisers Bates Investments. Hollands agrees: "In rising markets, cost averaging may be to investors' detriment, because they are losing out on that relative growth. It's more for someone who is concerned about short-term volatility."

Cost averaging can affect investors in other ways. Frequent trades may engender frequent fees, which eat into an investor's profits. However, direct purchase opportunities and the growth in trading on the Internet is cutting down the role of the broker and his fees, so frequent dealing is becoming more attractive and less expensive than it used to be.

One of the greatest benefits of cost averaging may be psychological. Although investors with a lump sum might do well financially to plunk it all down in one hit, cost averaging takes some of the trauma out of moving one's money from less risky assets like cash and bonds into equities. It also encourages investors to take a longer-term view, leaving them less inclined to panic and bail out at the first sign of market trouble.

Even as it helps soothe the nerves, cost averaging also nudges investors to develop savings habits that will stand them in good stead for putting together the nest egg they will need in retirement. "It's a very healthy discipline," says Hollands. For those eager to build a portfolio but who do not have a large lump sum to play with, it also makes sense in terms of regular cash flow. Says Hollands: "You're building a savings culture into your everyday budget." A savings culture that, even in turbulent times, gives wary investors a way to navigate a steady course through the equity market's rocks and shoals.