One strategy for accumulating shares and reducing the impact of price fluctuations is to “average” the position. By buying shares at different times, the investor accumulates the shares at different prices. Such a policy may be achieved through the dividend re- investment plans offered by mutual funds and many companies. An alternative is to systematically purchase shares of stock. There are two basic methods for achieving this averaging: the periodic purchase of shares and the purchase of additional shares if the stock’s price falls.
Periodic Purchases
Under the periodic purchase plan, the investor buys additional shares of a stock at regu- lar intervals. For example, you may elect to buy $2,000 worth of a stock every quarter or every month. This purchase is made at the appropriate interval, no matter what the price of the stock is. Since the dollar amount is the same, this technique is referred to as dollar cost averaging.
The effect of such a program is illustrated in Exhibit 10.1, which shows the num- ber of shares of EMEC stock purchased at various prices when $2,000 is invested each quarter. The first column gives the dates of purchase, and the second column presents the various prices of the stock; the third and fourth columns list the number of shares purchased and the total number of shares held in the position. The last column presents the average price of the stock held in the position. You should notice that when the price of the stock declines, $2,000 buys more shares. For example, at $33 per share,
$2,000 buys only 60 shares, but at $18 per share you receive 111 shares. Because more shares are acquired when the price of the stock falls, this has the effect of pulling down the average cost of a share. In this example, after two years the average cost of the stock had fallen to $23.85 and you have accumulated 671 shares. If the price of the stock subsequently rises, you will earn more profits on the lower-priced shares and thus will increase the return on the entire position.
dollar cost averaging The purchase of securities at different intervals to reduce the impact of price fluctuations.
Averaging Down
Some investors find it difficult to purchase stock periodically, especially if the price of the stock has increased. Instead, they prefer to purchase additional shares of the stock only if the price declines. Such investors are following a policy of “averaging down.”
Averaging down is a means by which the investor reduces the average cost basis of an investment in a particular security by buying more shares as the price declines so that the average cost of a share is reduced. This may be particularly rewarding if the price subsequently rises, because you have accumulated shares at lower prices and earn a gain when the price increases. You may dollar cost average, which means that you spend the same dollar amount on shares each time a purchase is made. Or you may average down by purchasing the same number of shares (i.e., share averaging) every time a purchase is made.
Exhibit 10.2 illustrates these averaging down strategies. The price of the stock is given in column 1. Column 2 uses the dollar cost averaging method; the investor pur- chases $1,000 worth of stock every time the price declines by $5. As is readily seen in column 2, the number of shares in each successive purchase is larger. The last entries in the column give the total amount that the investor has spent ($5,000), the total number of shares that have been purchased (289), and the average cost of the shares ($17.30).
The average cost of the total position has declined perceptibly below the $30 price of the initial commitment. However, if the price of the stock were to increase to $30, the entire position would be worth $8,670. You would have made a profit of $3,670 and earned a gain of 73 percent on the entire position.
Column 3 in Exhibit 10.2 illustrates the share averaging method, which means that the same number of shares are bought every time you make a purchase. When the price declines by $5, the investor buys 100 shares. If the price of the stock were to fall to $10, you would have accumulated 500 shares under share averaging, for a total cost
ExhIBIT 10.1
Average Position When $2,000 in EMEC Stock Is Purchased Each Quarter
share averaging A system for the accumulation of shares in which the investor periodi- cally buys the same number of shares.
Date Price of
Stock Number of Shares
Purchased Cumulative Number
of Shares Owned Average Cost of Share
1/1/X0 $25 80 80 $25.00
4/1/X0 28 71 151 26.50
7/1/X0 33 60 211 28.44
10/1/X0 27 74 285 28.07
1/1/X1 21 95 380 26.32
4/1/X1 18 111 491 24.44
7/1/X1 20 100 591 23.69
10/1/X1 25 80 671 23.85
Source: http://stockcharts.com/freecharts/historical/djia1900.html.
of $10,000. If the price of the stock were to return to $30, the entire position would be worth $15,000, and the profit would be $5,000, for a gain of 50 percent.
There is a greater reduction in the average cost of the entire position with dollar cost averaging than with share averaging. When the investor dollar cost averages, the amount spent is held constant and the number of shares purchased varies. When the investor share averages, the number of shares purchased is held constant and the dollar amount varies. Because the investor purchases a fixed number of shares with share av- eraging regardless of how low the price falls, the average cost of a share in the position is not reduced to the extent that it is with dollar cost averaging.
The preceding discussion and examples explain the essentials of averaging. You may choose any number of variations on this basic concept. For example, you may choose to average down on declines of any dollar amount in the price of the stock or may select any dollar amount to invest for periodic purchases or for averaging down.
The effect is the same—that is, to reduce the average cost basis of the position in that particular security.
Averaging down obviously requires that you have the funds to acquire the additional shares once the price has declined. Such purchases may not be cost-efficient when considering commissions. Dividend reinvestment plans that permit additional contributions may alleviate the problem of commission costs, but the purchases then cannot be made at a particular desired price. Instead, you must accept the price on the day the funds are invested.
If you follow a policy of averaging down, you should not assume that such a strategy will lead to a positive return. The stock’s price may continue to decline, or many years may pass before the price rises to its previous level. You should view the funds spent on the initial investment as a fixed or sunk cost that should not influence the decision to buy additional shares. This type of reasoning is difficult to put into
ExhIBIT 10.2
Averaging Down Strategies
Price of the Stock Number of Shares Purchased
($1,000 Each Purchase) Cost of 100 Shares
$30 33 $ 3,000
25 40 2,500
20 50 2,000
15 66 1,500
10 100 1,000
289 shares (for a cost of $5,000 and an average cost
of $17.30 per share)
$10,000 (500 shares, for a cost of $10,000 and
an average cost of
$20 per share)
practice. Many individuals will not readily admit that they have made a poor invest- ment. Unfortunately, they then follow a program of averaging down in the belief that it will vindicate their initial investment decision.
You should not automatically follow a policy of averaging down. Before additional purchases are made, the stock should be reanalyzed. If the potential of the company has deteriorated (which may be why the price of the stock has fallen), it would be wiser to discontinue averaging down, to sell the stock, and to take a tax loss. If the stock lacks potential, it makes no sense to throw good money (the money used to buy the addi- tional shares) after bad (the money previously invested in the stock). Some questions that should be asked are “Does the firm still have potential?” or “Is there a substantive reason for maintaining the current position in the stock?” If the answer is yes, then averaging down and periodic purchases are two means of accumulating shares while re- ducing their average cost basis. Such strategies reduce the impact of price fluctuations, but it cannot be assumed the strategies produce superior returns, since excess returns are inconsistent with the efficient market hypothesis. Averaging strategies do, however, offer a means to save and systematically accumulate securities.
SUMMARY
Securities prices fluctuate daily. Many averages and indexes have been developed to track these price movements. Aggregate measures of the market include the Dow Jones averages, Standard & Poor’s stock indexes, the NYSE index, the Russell stock indexes, and the Value Line stock index. There are also measures of segments of the market (e.g., large cap stocks) or sectors (e.g., tech stocks).
The composition and method of calculation of each measure differ. The compo- sition ranges from the Dow Jones Industrial Average of 30 companies to the Dow Jones Wilshire 5000, which encompasses over 7,000 companies. The method of calcu-