We can cost average up into an investment when it is going up. Though it is contrary to what most investors do, there are many reasons why it may be a good investing strategy.
Content
- Introduction
- Reason to Cost Average Up
- Risks of Cost Averaging Up
- Best Assets to Cost Average Up
- Conclusion
Introduction
Cost averaging up is an investment strategy that consists in increasing those positions in our portfolio that are going up in price. It can be carried out with all types of investments and asset classes, including exchange-traded funds and individual stocks.
If we cost average up with individual equities, we will buy additional shares as the stock price rises. As a consequence of that, the average price we have paid for that company’s shares is increasing.
Let us illustrate this with an example:
- We bought 100 Apple shares when they traded at $100.
- When its price goes up to $110, we buy 100 more shares, making the average price paid for our Apple shares $105.
- If later on Apple rises to $140, we can buy 100 more shares, increasing the average price to $120.
As you can see, as the stock price has been rising, we have decided to buy more shares. Therefore, the weight of this asset in our investment portfolio has grown significantly, as both its price has gone up and we have increased our position.
Although some investors may think there is no rationale for that, there are situations in which it can make sense. When we cost average up, we are betting heavily on our winners.
Reason to Cost Average Up
Most people make the mistake of selling stocks that have gone up in price, to buy more shares of stocks that have dropped in price. And this is often a mistake, as price changes are usually justifiable.
If a stock price goes up, chances are the company is improving. Perhaps the business is growing, profits are increasing, or a discovery has been made that will have a positive impact on the future of that company.
Consequently, while it is true that bubbles can form in individual stocks, most often that is not the case.
We can use Apple as an example. Its stock price has been going up for a couple of decades. Since Apple launched the first iPod to the market, both revenue and profits have skyrocketed. As a result, the valuation of the company has increased tremendously.
It is true that there may be short- and medium-term corrections in an upward trend. But if the company’s business is improving, the logical thing to expect is a sustainably higher stock price.
Conversely, constant price drops are often indicative that a company’s business is deteriorating. Think of companies like Blackberry or Deutsche Bank. Their stock prices have been plummeting for over a decade. But their business prospects are a lot worse nowadays than they were when they dominated their markets.
Therefore, the logic for cost averaging up is to continue to bet on the winners of our portfolio. Instead of selling winners and buying losers, we do the opposite: we sell losers and buy winners.
While this can be though of as a momentum strategy, where we simply buy what is going up, we focus on the fundamental reasons for those higher prices: profitable and growing businesses.
Risks of Cost Averaging Up
There are some risks associated with cost averaging up as an investing strategy. We must remember that, given that we buy more shares when the stock price goes up, our average cost price is continually increasing.
Consequently, the biggest risk of averaging up is that the stock price will drop and not recover after we have already accumulated a significant number of shares.
Returning to the example we used at the beginning, where we bought more Apple shares as the stock price went up, there is no doubt that, if there was to be a crash, it is riskier to own 300 shares at an average price of $120 than only 100 shares at an average price of $100.
Because of that, we should always ask ourselves if those stock price increases are sustainable in the long term before we buy additional shares.
In the case of Apple, if we analyze the last two decades, we will realize that most of the time, a higher stock price was justified by increased sales and profits.
However, there might have been instances where a rally was triggered solely by an expansion in its valuation multiples. Whenever that happens, we should be cautious before averaging up in our positions.
Best Assets to Cost Average Up
Let us discuss the two types of investments with which averaging up is usually a good idea: assets with good fundamentals, and assets whose time has come. Let us expand on that.
On the one hand, it is generally a good idea to cost average up into quality assets. Quality assets have a promising future and strong fundamentals.
Many assets fall into this category: companies with solid balance sheets whose businesses are improving, global stock ETFs, gold, real estate in safe jurisdictions, etc. Notice how all these assets are likely to exist decades from now. Therefore, we minimize the risk of being zeroed out.
On the other hand, there are riskier assets with which we can average up as long as it is the right time to do so. If market and economic conditions have changed and are now more favorable to those companies, we can average up.
One example could be uranium companies. Between 2007 and 2017, the price of uranium dropped from $136 per ounce to less than $20. The stock price of uranium producers and exploration companies collapsed at the same time.
Nevertheless, the world is still dependent on nuclear energy. Several countries are building new reactors, and demand for uranium is set to increase in the future.
Consequently, many investors believe that it is only a matter of time before the price of uranium goes up again. When that happens, uranium stock prices can skyrocket.
In such a scenario, averaging up with shares of uranium-producing companies might be a good idea. An increase in their stock price may be the signal we need to know that a new bullish cycle has started. And we will position ourselves to tack advantage of it.
Conclusion
Averaging up is not for everyone. Many investors are tempted to quickly sell those stocks that have gone up in price and lock in that profit. However, that is generally not a good investment strategy.
When it comes to investing our capital, time is one of our greatest allies. Time makes it possible for our investments to grow and take advantage of compound interest. That is why time in the market is more important than timing the market.
If something has worked for us so far, why should we sell? Betting on our winners has historically resulted in good returns. Averaging up is just one way we can bet on our winners.
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