Value Column von Hans Peter Schupp

3. JULY 2023

The cost-average effect: A clever strategy or just an expensive myth?

Fund savings plans have been a common way for investors to build up their assets for many decades. The reasoning is simple: if you save a fixed amount each month in a fluctuating form of investment such as stocks, you automatically buy more shares when prices are low. Over a certain period of time, the average share price in the investor’s portfolio is thus lower than the average price in the market. This is a clever way for investors to take advantage of price fluctuations. Return and risk are thus in a reasonable proportion, because the cost-average effect is used.

Criticism on the cost-average effect

But is this true? Well, the rationale has been criticized again and again, most recently in a commentary in German financial magazine Wirtschaftswoche of June 18, 2023, entitled „This myth costs money.“ As early as 1994, Paul Samuelson, winner of the Nobel Prize for Economics, called advertising with the average cost effect a „blunder, if not a crime“. Understandably, the methodological approach is questioned when returns are arithmetically averaged. Here is an example: a stock price falls -50 percent and then rises +100 percent to its initial value. The average return is +25 percent (-50 percent +100 percent / 2), although nothing was earned over the entire period.

The proper calculation in this case would be the geometric mean (1 -50 percent)*(1 +100 percent) -1 = 0.

Furthermore, it is argued that in the case of a savings plan, much less money is tied up on a time-weighted average than in the case of a one-time investment, and that returns are therefore not meaningful. Although this is also correct in terms of content, it says nothing about the cost-average effect. It only shows that the savings plan – as the name suggests – is a form of asset accumulation, whereas the one-time investment is a reallocation within an existing asset.

Cost-Average-Effect as an essential part of our investment process

For us, however, the cost-average effect is an essential part of our investment process, and not just for return considerations, but rather in view of potential risk. Just as assets should be diversified across multiple securities, it also makes sense to spread the acquisition of those securities across multiple points in time.

Admittedly, this approach is challenged in the academic literature, as it only works if prices in the investment period are also lower than at the time of the investment decision. If not, one just tries to catch up with rising prices. However, this criticism mainly applies to momentum strategies, which are mostly implemented in growth companies. However, this is not our investment approach. We follow a contrarian value approach, in which we often invest in companies very early and then add to our position when prices fall.

An example: much too early and much criticized, we invested in Deutsche Bank shares after the Brexit decision in 2016 and consistently increased this position further until its low point. In the meantime, this has become a very successful investment. But one had to be hard-bitten for that.

Re-balancing as a core factor of our strategy

Re-balancing is even more important for us. Here, too, we are talking about cost averaging. Price fluctuations on the stock markets cause the asset allocation of the portfolio to change due to differences in the performance of the individual assets, and these deviate to varying degrees from their target allocation. By selling some of the outperforming stocks and buying others with poorer performance, the desired risk level is maintained.

There are two strategies for doing this. The adjustment can be either time-based or bandwidth-based. Depending on how timely the portfolio is to be trimmed, these adjustments can be made either at a cut-off date or when certain tolerance limits have been exceeded. The latter is used in the Contrarian Value fund because we naturally monitor the performance of our portfolio on a daily basis and intervene immediately if the deviations from our target allocation become too large. Mostly, we use the inflows and outflows in the fund for this purpose.

Cost-average effect – a useful instrument for reducing risk

Conclusion: Even if criticism on the cost-average effect is justified, in our opinion it is a thoroughly sensible instrument for risk reduction in an existing portfolio and for asset accumulation. Despite the positive performance of our Contrarian Value Euroland fund since its inception, it has proven advantageous for our investors to initially make a basic investment due to the volatile performance of the fund and then to increase the position in several steps over time depending on the market assessment and risk appetite – in other words, to engage in cost averaging.

Translation for convenience only!

The author: Hans Peter Schupp is a board member of FIDECUM AG and portfolio manager of the Contrarian Value Euroland fund.