The Cost Average

Does the Cost Average work? What is this at all?

As the name suggests, the cost average shows the average cost. It is used in a lot of places in the economy and are taught in even more places.
And obviously it should work if it is used so much. Or not?

The Cost Average in Everyday Life

You use the cost average method not just in finance. If you happen to be running inventory management for a business, you may have chosen the average cost to keep track of it.

Then you will be able to tell exactly how much the company has always bought the given raw material at the current market price, on average. That is, for how much should be sold in order not to incur a loss.

Here’s how it works for inventory management:

purchase: 100 pcs, 10 HUF / pc. Total value: HUF 1,000
purchase: 20 pcs, 15 HUF / pc. Total value: 300 HUF
purchase: 200 pcs, 8 HUF / pc. Total value: HUF 1,600

Thus, the company now has 320 raw materials, which are worth a total of HUF 2,900. This is an average value of HUF 9.06.

When does the business benefit from the average cost?

It can came them handy in two cases. On the one hand, when they buy (suppose, on a regular basis), and try to get it as cheaply as possible. They are not panic or not in doubt when prices fall because it pushes down their own average cost and increases their chances of profit.

On the other hand, when it sells, it aggregates the raw materials and preferably does not sell below that value.

Using the Cost Average

In finance, people tend to think the other way around and are scared when the exchange rate falls.
My question is, if you could choose from the following two options to invest every year, which one would you choose?

I bet you choose the A. You choose the one that goes up. No matter, we don’t argue, the other one will be good for me.
The essence of the method can best be summed up there, that you always buy a little, so you can win even if the market falls, and then when it rises, you make profit at the higher price.

Let’s look at the numbers a bit.

The operation of the cost average in the long run.

Take John, who decided to invest every year. If we are really looking at the long term, it is advisable to look beyond the Hungarian possibilities. After all, it was still in its beginning state back home at the time.

That’s why we look at John investing abroad and being so “bourgeois” that John has put aside not forints but dollars, for the sake of simplicity, $ 100 every year. Plus, from 1991, and fate brought it so that John needed all the money in early 2019, so he sold everything.
At today’s exchange rate of $ 100, it hovers around HUF 30.000, which is a very allowable amount today. From 1991 onwards, if we took only HUF 30.000 as a basis, it would turn out that John would have worked for it very long, but at that time $ 100 was about one-third of the average monthly salary. So not only was John able to afford that amount each year, but now he was able to win on the exchange rate shift as well. To eliminate this, the dollar will be the narrative of the results.

Example of long-term application of cost average

To make it easy to compare, we’re not looking at a specific product that would be put on the client’s desk as a financial advisor right now, after all, there can be a lot of variance in that.
Let’s look at the S & P500 stock index instead. I chose this because it tracks the current state of the economy quite well and has been around for a long time, so it’s easy to use for comparison. If John hadn’t put her money into just that, she would have run into something similar elsewhere, at most the curve would have shown a greater fluctuation.

This is what the graph looks like:

Let’s look at the effect of cost average on Jani’s money set aside in three cases.

1. If he only invest that $ 100 at the beginning of each year
2. In addition, he inherits $ 1.000 in addition to $ 100 and invests it in a lump sum at the very beginning
3. The inherited $ 1.000 is invested in equal parts in addition to $ 100 in the very first 5 years.

This is how Jonh’s investment develops over time:

What the heck, cost average?

Why use it when it doesn’t work? 🙁 Would the many financiers who suggest this speak nonsense? Why use one at all when you can see that it’s not better to always buy a little? After all, the result of $ 5 * 200 was worse than that of $ 1,000 at a time.

Why didn’t the cost average work?

Maybe slow down a little. The cost average acts as a means of atomizing risk. And like any device, it has its own “instructions for use” or optimum.
If you look at the graph, you can see that it is basically moving upwards. Thus, in a rising market, the effect of how much time it takes, how much money you can work on has a much stronger effect on the end result. If you look closely, compared to the original 1.7 M, the 3 M HUF achieved a result of roughly another 30 years for John, even though he “only” invested 10 years.

The operation of the cost average in the medium term

Let’s see what would have happened if John hadn’t started in 1991. After all, there may be many of us who were still very far from finances at the time. I myself was in the primary school, so let’s jump in time and suppose John starts saving in 2007 and the situation makes him need the money sooner. That is why he will take out his money in 10 years, not in almost 30
Let’s look at it here if you add the $ 1.000 plus in the same amount, or in 5 years

Oops!

Something else happened here. There was a crisis between 2007 and 2017 that pretty much eroded the exchange rate. And here came the true power of the cost average. It was already visible here that even though the 2007 money worked more, the shares was “cheaper” in 2008 one, so the benefits could be greater.

Because a crisis at most can be felt, but not accurately predicted for the day, most financial advisors have a calm heart to recommend that you use the cost average.

You can win with it in the same way as the company above, which bought the raw material cheaply but sold it at the same normal market price. Thus, his profits increased.

In summary

The cost average does not give a significant plus to the investment in the very long run. Rather, psychologically, one has a sense of security. In 10-15 years or less, however, we can definitely achieve extra results with it, even when a significant part of the world is panicking.

If you want to win on your investment, you don’t just want to take advantage of the cost average effect. After all, it means you have less time left to work on your money. Invest all your money and use diversification instead. That is, divide it between different devices, not divide it in time.

Questions:

What do you think, if there is a time maximum of the cost average efficiency, what could be the minimum?
How can you benefit from a crisis?
Why do you think the cost average is not widely used among small investors?

I am happy to read your views and comments. If you have a specific question or would like to use this effect, you can also ask it via the contact menu item.