Trying to time the stock market is very tempting for novice investors. Stocks go up and down every day. Our brains try to find patterns in stock charts and to predict the next movement. Moreover, the financial media wants to grab your attention by producing headlines about rising and falling prices and recommending the next hot stock. Their goal is to generate clicks, sell magazines, or make you spend your hard earned money on transaction costs. It is not easy to ignore this noisy crowd if you are just starting out. In the following we explain how you can use cost averaging to your advantage.
Be honest: it would be too good to be true being able to buy a stock at its bottom and sell it at the top at a consistent basis. It is what it is: too good to be true. Have you ever heard of anybody who was able to repeat it regularly? He would be the richest person on the planet in a short time. So, don’t even try it (we both know you will… don’t). The only people who might make money from timing the market are professional day traders. It is a different ball game. We are interested in consistency and reducing risks.
Diversification Over Time
Imagine you decided to deploy $2,500 in a certain stock. A very common approach among dividend investors is to distribute the purchase of a stock into several tranches over time. For example, you could split-up the $2.500 into five tranches $500 each. The buy orders might be executed at the beginning of each month. This approach is called cost averaging.
Cost averaging helps you to diversify your purchases in one stock over time. Diversification over time and stock sectors is one of the best tools to reduce the risk in your portfolio. You give-up the dream of buying the absolute bottom and are satisfied with a consistent average price.
Following types of cost averaging transactions are possible:
Averaging Down: The purchase of shares that reduce the average share price of a stock position in your portfolio is called “averaging down”.
Averaging Up: Buying shares that increase the average share price of a stock position in your portfolio is called “averaging up”.
The next section will show a brief example of how cost averaging works.
Cost Averaging Example
In the following, we assume you want to invest $2.500 into a certain stock. The shares are currently trading at $50.0. Instead of investing a lump sum you decide to split-up your money in 5 tranches. So, you buy 10 shares at the beginning of the next five months.
The transactions might look something like this:
|Transaction||Price per Share||Average Share Price|
Instead of trying to get all shares for $44.60 or having the risk of purshasing all shares at $50.0 you get the average share price of $47.88. As you save further money or receive dividend payments you can continue to cost average in the future.
Important: If you split your purchases into serveral tranches you have to keep an eye on the transaction costs. If the tranche size is too small the transaction costs might get too high in relation to the overall transaciton size. For example, if your transaction size is $500.0 and your provider charges $2.0 transaction costs, the costs correspond to 0.4% of your transaction size.
Cost Averaging in the 22 Dividends App
The 22 Dividends app helps you to keep track of your buy and sell transactions. The cost averaging information is diplayed on the transaction page for each stock:
All buy and sell transactions are visualized as green and red dots in the stock chart. Thus, you can easily see the distribution of your purchases over time in relation to the share price. Moreover, the blue line represents the average share price of your position.
The transaction details are visualized as cards below the chart. The latest transaction is at the top of the list. Each transaction has an icon that represents the type of the transaction in regard of cost averaging (e.g. average up/down, or initial purchase).
The first line depicts the buy date and the stock exchange. The second line shows how many stock you bought/sold at what price. The last line depicts the absolut and relative transaction costs. For example, the transaction above costs 0.43% of the transaction value.
Trying to time the stock market is a loosers game. You only hit highs and lows by accident. There is no secret. Focusing too much at share prices is distracting. What counts is buying a great business at a good price.