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Wednesday, July 28, 2010

Cost Averaging & Value Averaging

You start investing, and find yourself buying in at the top. Then, prices stumble and you sell, precisely at the bottom.

Like the pendulum that keeps on swinging back and forth, investor sentiments tend to alternate between periods of enthusiasm and despair.

Unfortunately, many investors are guided by their emotions and allow the mood of the market to dominate their investment decisions.

No one can consistently predict the tops and bottoms of the stock market.

History has proven that correctly predicting the timing and extent of stock market trends is impossible. This is because world developments and the psychological reactions of people are completely unpredictable. It's no surprise that a foolproof winning formula remains elusive.

One effective strategy for overcoming the emotional hazards of investing is the cost averaging approach that imposes a discipline that relieves the investor of grappling with uncertainty and volatility in the securities markets.

Cost Averaging

Cost averaging is a systematic investment plan involving buying equal amounts of an investment at set intervals -- monthly, quarterly, and so on.

Cost averaging is most prevalently used by investors who don't have lump sums to invest, but would like to accumulate an investment portfolio over time.

Strategically, cost averaging forces investors to be in the market when prices are depressed, but it also forces you to buy when prices are high.

Cost averaging does not assure a profit or protect against loss in declining markets. Because such a strategy involves periodic investment, you should consider your financial ability and willingness to continue purchases through periods of low price levels.

For investors with lump sums to invest, but who are afraid of entering the market prior to a correction, cost averaging will help to ease them into the market.

Value Averaging

Value averaging also capitalizes on the cost averaging systematic approach. It works in much the same way as cost averaging, but with value averaging, you decide on a target amount to invest, then adjust your monthly contributions to maintain that target.

Like cost averaging, value averaging can help lower your average cost per share. But value averaging goes one step further.

Because you end up investing more money when prices are low and fewer when prices are high, you have the opportunity to reduce your average cost per share even further.

It's a strategy that doesn't try to outguess the market's fluctuation, but rather seeks to make those fluctuations work for you.