I wanted to take the time today to talk to you about a tool that is available to all investors. The tool is called unit-cost averaging or rand/dollar cost averaging.
If I buy a single share at the price of R100 and then another share of the same company at the price of R50, what is my average cost? To get the average cost we add the cost of the shares and then divide by 2. R100 + R50 = R150 / 2 = R75. Why is this important?
If I buy a share with R1,000 when the share price is at R100 and the share price drops to R50 I have lost 50% of my investment capital (on paper). So I took R1,000, bought these shares and the value of my capital invested is R500 after the decline in share price. So in order to make back my loss the share price has to double again for me to get out at break-even. To make this clear, the share price needs to increase by 100% to allow me to get out the money that I initially put in. A 100% return is a lot to ask for.
Now I want you to imagine that I take another R1,000 and buy more shares at R50 after the share has dropped. Its never an easy thing to do. Our brains tell us to cut our losses and avoid further pain. This is why people end up selling low and buying high. The exact opposite of what they should be doing. This is where unit-cost averaging becomes so important. Now that I have bought more shares the average cost I paid for the shares now becomes R75 per share instead of R100. To get out at break-even and save my R2000 capital the share price only needs to reach R75 instead of R100. It’s a lot easier to ask for a share to go up by 50% instead of 100% don’t you agree?
It’s not a coincidence that I’m writing to you about this concept now. Yes, the markets have done poorly In Oct/Nov 2023. But I want you to know that if you have a regular debit order set up then you will benefit from these lower market prices by buying in lower. The crude image I put together below on MS paint illustrates the point I’m trying to make. Which investment would perform best if you were buying the same amount regularly?
If you said C, you would be correct. It would not be the most enjoyable of investment journeys but at the end of it you would come out pretty well off. The reason for this is that you were consistently buying shares at a low price, then the market turned and ran to the upside putting you in profit . You would certainly also have done well with A but your average unit cost would be much, much higher than C.
So, when markets take a dip, smile (despite the pain) and buy a little more than usual.