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Retire Rich with Cost Averaging Stock Investments
In buying an equity whose market price varies considerably over the years, the habit of consistent, long-term saving of small amounts has pronounced advantages, in addition to the more obvious effects on saving versus spending. In principle, these advantages apply to any type of equity, but often the minimum practical unit is too expensive for frequent buying by an investor with an ordinary amount of savings.
But a man saving as little as $100 a month is not barred from steady buying of corporate stock, for he can take his choice among plans offered by several mutual funds. Here we opt for a non-dramatic investing strategy, placidly buying a few shares periodically, whenever savings are available.
If a man buys stock without regard to the current price, what assurance can he have of obtaining a reasonable cost? Roughly the answer is that the more steadily and uniformly he buys, the better his chance.
Whenever an investor buys stock he pays today’s price, and he never knows whether the future will show that today’s price was low or high. By buying regularly, he automatically pays prices ranging all the way between the two extremes of the prices that are offered during the period of time he is buying. The average of the prices he pays is fairly sure to be close to the average of all those quoted during the period.
Although the price of a stock may change considerably in a few months, the major changes in price, especially on a broadly diversified fund, take several years to develop. The highest price quoted at any time during a given year may turn out to be low compared to the lowest price offered during the next several years, and vice versa.
Assuming that future price fluctuations will somewhat resemble those of the past, an investor needs to continue buying regularly for around five years in order to cover a sufficient price range so that the average of the prices he pays is pretty sure to be reasonable. Spreading purchases over enough years is much more important than the timing within any one year.
Now let us examine more closely what is meant by cost averaging buying. Suppose a man made just two purchases of a certain stock, paying $20 a share the first time, and $10 the second time, the average of those two prices is $15. But when each time he put in the same amount of cash, $100, so that when the price was $20 he got five shares, and when the price was $10 he received ten shares, a total of fifteen shares for $200. His average cost, $200 divided by 15, was $13.33, and this was considerably less than the average price of $15.
From this example it is obvious that by investing the same number of dollars each time, a man is bound to come out with an average-cost lower than the average of the prices he pays. This automatic advantage is called cost averaging. No matter whether the average of the prices a buyer pays is high or low, cost averaging works in his favor. Of course, it is better also to buy steadily and long enough to obtain a good average of prices.
If a man is saving with the intention that some day, when his salary is reduced or stopped, the income from his capital will be big enough to support his family, then he had better form a fixed habit of reinvesting all income from investments and, as long as his salary permits, also of saving some of his pay. The importance of this attitude grows as a man approaches retirement age and his income from capital is growing.
Suppose a middle-aged man’s annual salary is $100,000, and his income from investments is $20,000. He thinks of his income as being $120,000 a year. But what will happen to his family’s standard of living when his salary stops, and his income from investments has risen, let us say, to only $30,000? It would be so much safer for him to think of his income as being only from his salary, out of which he should continue to save a substantial amount.
Avoiding the receipt of cash income from investments is a comparatively smarter way to save, because you get into the compounding effect of your earlier investments. In some forms of investment, not paying income in cash has long been the rule. On a savings deposit, a bank adds a dividend to a depositor’s balance, not paying cash un¬less he asks for it. An E-bond owner receives income only in the form of added value when he cashes part or all of a bond.
On most other bonds, cash interest is paid periodically. Also, dividends on most corporate stock issues are paid only in cash. On these bonds and stocks, an owner wishing to reinvest must act individually, using the cash income to buy more bonds or stock. But in nearly all of the mutual-fund investment companies, a stockholder can give the company standing instructions to use his dividends to buy more shares instead of sending him cash.
An investor needs to realize that in order to obtain the best results from systematic buying, he must be able to save and invest just as many dollars in a year when stock prices are low as when they are higher. This may be difficult for him, because poor business conditions cause his income to drop at the same time that stock prices are down. Also, he must have the backbone to continue buying when the stock-market atmosphere is gloomy. These drawbacks are not an argument against the principle of steady buying; we mention them here merely as a warning against expecting too much.
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