When buying a stock whose market price has fluctuated significantly over the years, the habit of consistently saving small amounts over the long term has distinct advantages, in addition to the more obvious implications for saving versus spending. These advantages apply in principle to any type of stock, but often the minimum practical unit is too expensive for frequent purchase by an investor with a normal savings amount.
But a man who saves just $100 a month isn’t prevented from constantly buying company stock because he can choose from plans offered by several mutual funds. Here we opt for a non-dramatic investment strategy, calmly buying a few stocks regularly when savings are available.
If someone buys stocks regardless of the current price, what assurance can they have of getting a fair price? The answer is roughly: the steadier and more evenly he buys, the better his chances.
Whenever an investor buys stocks, they pay today’s price, and they never know if the future will show that today’s price was low or high. By buying regularly, he automatically pays prices that fall between the two extremes of the prices offered during the period in which he is buying. The average of the prices he pays is almost certainly close to the average of all prices quoted during the period.
Although a stock’s price can change significantly in a matter of months, the big price changes, especially in a broadly diversified fund, take several years to develop. The highest quoted price at any time during a given year may prove low compared to the lowest quoted price over the next few years and vice versa.
Assuming that future price fluctuations will be similar to those of the past, it would take an investor to buy regularly for about five years to cover a sufficient price range for the average price they pay to be almost certain to be reasonable. Spacing purchases over enough years is far more important than timing within a year.
Let’s now examine in more detail what is meant by cost averaging buying. Suppose a man buys a particular stock only twice, paying $20 per share the first time and $10 the second time, then the average of these two prices is $15. But if he put in the same amount of cash each time, $100, a price of $20 would get him five shares, and a price of $10 would get ten shares, a total of fifteen shares for $200. Its average cost, $200 divided by 15, was $13.33, and this was significantly less than the $15 median price.
From this example it is clear that if a man invests the same number of dollars each time, he is bound to come out with an average cost that is lower than the average of the prices he pays. This automatic advantage is called cost averaging. Regardless of whether the average of the prices a buyer pays is high or low, the averaging works in their favor. Of course, it’s also better to buy steadily and long enough to get a good average price.
If a man saves with the intention that some day, when his wages are reduced or discontinued, the income from his capital will be large enough to support his family, then he had better develop a firm habit of dedicating all income from investments reinvest and, as long as his salary allows, also save part of his salary. The importance of this attitude increases as a man approaches retirement age and his capital income increases.
Suppose a middle-aged man’s annual salary is $100,000 and his investment income is $20,000. He estimates his income at $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 increased to, say, just $30,000? It would be so much safer for him to consider his income only from his salary, from which he should continue to save a significant amount.
Avoiding cash income from investments is a comparatively wiser way of saving as you get caught up in the compounding effect of your previous investments. With some forms of investment, it has long been the norm not to pay out income in cash. With a savings deposit, a bank adds a dividend to a depositor’s balance and doesn’t pay cash unless requested. An e-bond holder only receives revenue in the form of value added when redeeming some or all of the bond.
Most other bonds pay regular cash interest. Also, dividends on most corporate stock issues are paid in cash only. With these bonds and stocks, an owner wishing to reinvest must trade individually and use the cash proceeds to purchase more bonds or stocks. But in almost all mutual fund investment companies, a shareholder can issue standing instructions to the company to use its dividends to buy more shares, rather than sending it cash.
An investor must recognize that in order to get the best results from systematic buying, they must be able to save and invest as many dollars in a year when stock prices are down as they would in a year when they are which they rise. This can be difficult for him as poor business conditions cause his income to fall at the same time as stock prices fall. Also, he must have the backbone to keep buying when stock market sentiment is gloomy. These disadvantages are not an argument against the principle of constant purchase; we mention them here only as a warning not to expect too much.