There’s often irrational panic in investment markets.
Most recently that’s been due to the Wuhanvirus/coronavirus/covid19 scare.
If you’re selling while the stock market is falling, you’re losing money.
You want to buy low, and sell high – but since you can never know where either the bottom or top is, how can you mitigate against market ups and downs?
What is cost averaging? It’s a way of hedging your investments against momentary swings in the stock market by lowering your average cost of each share.
A simplified cost averaging example for Universal Widgets Inc.
Universal Widgets Inc (UWI) is trading today for $10 per share. You like the company, and decide to buy $1680 in UWI shares (a total of 168 shares).
Next month, UWI has dropped to $7 per share. You still believe in the company’s future, and you still have $1680 to invest in the market, so you buy another $1680 worth of UWI stock at $7 per share (240 shares total).
Two months later again, and UWI has dropped to $3/share. Perhaps your confidence in the company has dropped some, but if you sell now, you’re guaranteed to lose over $2000! So instead of selling, and guaranteeing your loss, you again buy $1680 in shares (560 more).
You now have 968 shares of UWI that cost you $5040.
But they’re only worth $2904.
What share price does UWI need to hit in order to show a profit?
Now you merely have a simple math problem: take the cost, subtract the value, and divide by total shares: (C-V)/S
$5040 – $2904 = $2136
$2136 / 986 = ~$2.21
So when UWI gets back above $5.21 per share, you’re in the black.
If/when it recovers to your initial purchase price of $10, your portfolio will be worth $9860!
By cost averaging, you’ve reduced your risk, and increased your likelihood of coming out ahead when investing
This is, more-or-less, how some mutual funds grow (and why beginning investors (and most seasoned investors) should buy-into mutual funds instead of individual stocks).