The investment method which results in the cost average effect is known as unit cost averaging or (in the USA) as dollar cost averaging.
This term “cost average effect” describes the mathematical phenomenon which occurs when you make a set of smaller, identical investments in securities (which have fluctuating rates).
When you buy securities via a set of identical investment sums, you buy more securities when the price of those securities is low than you do when the price is high. A mathematical consequence of this practice is that the average purchase price per security generally equals the harmonic mean average of all the purchase prices.
If you were to buy an identical number of securities regularly, albeit at fluctuating rates, the result would be that the average purchase price paid would equal the arithmetic mean average of total purchase prices. Because the harmonic mean is lower or equal to the arithmetic mean, this cost average strategy is more cost-effective than investing a fixed amount of money regularly. It is also important to note that the more volatile a security is, the stronger the effects of the cost average effect are. This applies regardless of whether the price of a security is trending upwards or downwards.
A single, one-off investment can be even more beneficial than making the same investment as a series of equal investments using the cost average strategy. However, when you invest the full amount in one go you bear the risk of buying all your securities at the wrong time. The cost average effect reduces the risk of making unfavorable investments, but it also reduces the chance of making favorable investments.
Some financial experts believe that the cost averaging promoted by investment funds is primarily a marketing ploy. Savers and investors which would shy away from investing large amounts of money in one go (or are unable to do so) may more readily invest through a series of smaller payments. The threshold for making numerous smaller payments automatically is lower in the case of many small savers.
Fund administrators and salespeople also profit from the fees generated. Some funds charge non-percentile fees for each transaction. In this case, a one-time investment works out cheaper. The benefits of the cost average effect may be reduced in this case.
More on this topic:
Compounding interest effect
Compound interest calculator
Equity trading comparison tool
