Behavioral finance FAQ / Glossary (Cost averaging)

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This is a separate page of the C section of the Glossary

 

Dates of related message(s) in the
Behavioral-Finance group (*):
Year/month, d: developed / discussed,
i: incidental

Cost averaging

See commitment, loss aversion,
sunk cost fallacy

Spending more money when losing money?

Definition:

For an investor, cost averaging (called also, guess where, "dollar cost
averaging") is purchasing an additional quantity of an asset (stocks
for example) after its price fell
.

Motivations and consequences

After risking a finger, risking the whole arm.

This practice can be a symptom of loss aversion / get-eventis (see those
phrases) under the pretence of reducing the average cost.

It is true that it gives a lower average buying price.

But the holder gets a larger quantity of stocks,
thus increases its amount at risk.

This goes against efficient diversification, and might
be throwing more money into the same bottomless
hole.

Loss aversion, but also commitment (see those terms in the glossary)
might explain this practice
of lowering the average unit cost, but at the price
of a bigger risk.

As regards commitment, the most an investor pour efforts and money into
an asset,

* the more he becomes emotionnally committed / addicted to it,

* the less he will accept to change course (see endowment effect).

Practices that differ
         from crude cost averaging

Gathering nuts one by one, squirrel-like.

Cost averaging as a purely reactive behavior is not to
be  confused with an initial strategy

to buy gradually


(whether the price falls or not), and and to stop buying
once the initially projected quantity is acquired.

This strategy can even be systematized in an investment plan,
that for  example allocates of a fixed monthly amount to stock investing,
whatever the market situation.

=> Thus more shares are bought when prices are low
      than when they are high.

This cumulative method has the psychological advantage that it makes
people invest with a long term view but it has the drawback to neglect
timing.

Averaging down, averaging up

Last but not least, what is usually called cost averaging is in fact
negative price averaging
as it tries to lower the average price.

But this is just one way and one motive to "average" price.
A positive cost averaging is also possible,

for example by increasing an investment in an asset which a price
trend goes upwards for what seems good reasons,
thus is seen
as a confirmation that to invest in that asset is (or at least was) wise.

This is OK if it is not just blind trend following and if it doesn't build a
too large holding in that asset, thus neglects diversification.

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This page last update: 06/09/15  

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