The cost averaging effect is a fundamental principle in investing particularly associated with saving plans/saving schemes/individual investment plans. The cost averaging effect occurs when an investor consistently invests a fixed amount of money into mutual funds, exchange-traded funds (ETFs), or any other asset at regular intervals, regardless of the asset’s price at the time of purchase. The cost averaging effect can play a significant role in smoothing out the impact of market volatility over time. With regard to this, one needs to bear in mind that this effect gets smaller over time since the impact of the individual regular payment gets smaller as the overall value of the portfolio increases.
One of the key advantages of saving plans and, therefore, also of the cost averaging effect, is the ability to mitigate the risks associated with market timing. Many investors attempt to buy when they believe prices for an asset or market are low and try to sell when they are high. Unfortunately, it can only be told in hindsight if they have chosen the right point in time. Therefore, market timing or predicting short-term market movements is seen as one of the most difficult parts when managing a portfolio. The cost averaging effect reduces the necessity of trying to time the market, allowing investors to participate in both high- and low-price points. Over time, this results in purchasing more shares when prices are low and fewer when prices are high, thus lowering the average cost per share.
This strategy is particularly beneficial in volatile markets, where prices fluctuate frequently. By investing consistently, the investor can avoid making emotional decisions, such as selling in a panic during downturns or buying impulsively during rallies. The disciplined approach of cost averaging is in line with a proven successful long-term investor mindset, focusing on accumulating wealth gradually rather than seeking short-term gains. This makes the cost averaging effect especially useful for individuals who are investing for long-term goals, such as retirement.
While the cost averaging effect can lead to lower average costs over time, it is important to note that it does not guarantee profits or protect against losses in a declining market. However, it reduces the risks associated with investing a lump sum at the wrong time. By spreading investments over time, investors gain exposure to various market conditions, increasing the chances of capturing favorable prices while avoiding the anxiety of making a single large investment during a market peak. That said, scientific research shows that investing a lump sum might be advantageous compared to a saving plan over (very) long time periods. Nevertheless, this research does not take human behavior into account, which may rather lead to panic sells than cold-blooded hold decisions when the markets are going down massively. In turn, this means that investors who sell are most likely to realize losses instead of taking advantage of the long-term returns.
With regard to the above, it can be said that the cost averaging effect is a powerful tool for managing (timing) risk in investing. By following a disciplined, regular investment approach, investors can reduce their exposure to market volatility and benefit from lower average costs for their assets over time, fostering long-term financial growth. As mentioned before, the positive impact of the single payments for the overall portfolio is decreasing over the time, as the portfolio is growing. This effect can be offset by increasing/adjusting the respective saving rates.
This article is for educational/information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of LSEG Lipper or LSEG.
