Understanding Averaging Strategies

August 9th, 2017

Have you ever heard of dollar cost averaging or value averaging? It’s a strategy to avoid being exposed to price risk when making a large purchase in an actively traded security. Because if you make the investment all in one fell swoop, you might get lucky and see the price swing higher a few months after you buy in, but you could also see it drop significantly. For a buy-and-hold value investor, there are strategies to mitigate the risk and remove any aspect of short-term speculation.Have you ever heard of dollar cost averaging or value averaging? It’s a strategy to avoid being exposed to price risk when making a large purchase in an actively traded security.

Understanding-AveragesBecause if you make the investment all in one fell swoop, you might get lucky and see the price swing higher a few months after you buy in, but you could also see it drop significantly. For a buy-and-hold value investor, there are strategies to mitigate the risk and remove any aspect of short-term speculation.

Dollar Cost Averaging

A dollar cost averaging strategy is very simple. Instead of making your entire investment in one trade, you divide it evenly into trades over the course of a year. This way, the price per share that you pay will be the average of the security’s price over the year. If there are any big swings in price, they will have a lower impact on the size of your position.

For example, suppose you’d like to purchase $6,000 worth of ABC shares. You’ll buy as close to $500 worth as you can each month. Suppose the prices are as follows:

January: $50February: $45March: $50April: $31May: $36June: $36July: $39August: $40September: $45October: $52November: $48December: $46Your average price per share would be $43.16. With shares trading at $46 by the end of the year, you’d have earned a tidy 6.56%. If you had bought all the shares in April, you would have earned a lot more¾or the price drop may have persuaded you to choose another stock. If you bought in October, however, you’d have seen about an 11% loss! As you can see, the DCA method limits your exposure to price movements.

Value Averaging

Value averaging is similar to dollar cost averaging, but it factors in the growth of the position already held. Instead of contributing a fixed amount each month, you set a target growth rate, measured in dollars for each month. Whenever there is a shortfall in growth from the target, you buy more stock. If you exceed your target you sell some.

For example, we’ll extend the above situation. Instead of simply contributing $500 a month, you would set a growth target of $500 a month. The first month, you don’t have any shares so you buy 10 @ $50. The next month, the current stock price is $45/share, and the value of your holdings is $450. In order to reach your target of $1,000, you’ll need to contribute $550. However, by March, the stock price has recovered to $50 and your holdings are worth $1,100. In order to reach the $500 growth to $1,500, you only need to contribute $400. Here’s a table to illustrate more clearly:

Target Stock Price Shares Owned Current Value Contribution Shares AddedJanuary 500 50 0 0 500 10February 1000 45 10 450 550 12March 1500 50 22 1100 400 8One of the main drawbacks to an averaging strategy is the fact that you’ll probably pay more in brokerage commissions. Before implementing an averaging strategy, check to make sure you won’t be paying a small fortune in fees!

The example paragraph seemed like it might be a little hard to digest, so I included a table. If that doesn’t work for formatting, let me know and I’ll change the paragraph to a more general concept explanation.

Original Source: http://lmcu.frc.finresourcecenter.com/Savings__Investments_78918.html?article_id=2377

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