In investment, the term unit cost averaging denotes an investment strategy in which the total amount available for investment is broken up into a number of equal portions which are invested at regular intervals.
Unit cost averaging is used to reduce the risk of making a full investment under unfavorable conditions.
Example of unit cost averaging:
You want to invest in 1000 fine ounces of gold. The current going rate for gold is 1235 Swiss francs per fine ounce. The value of gold may go up, but it may also go down. If you were to buy the full 1000 ounces at 1235 francs per ounce (1,235,000 francs in total), you would risk losing a lot of money if the price went down. For example, if the price fell by 10 francs per ounce to 1225 over the next year, your investment would lose 10,000 francs of value.
Instead, you opt to use unit cost averaging. You buy 200 ounces of gold per week over a 5-month period. You buy the first 200 ounces at the going rate of 1235 francs, so you pay 247,000 francs. When you buy the next 200 ounces the next month, the price has increased to 1239 francs per ounce, so you pay 247,800 francs. The month after, gold has fallen back to 1235 francs per ounce, so you pay 247,000 francs. When you buy the next 200 ounces, the price is just 1229 francs per ounce, so you pay 245,800 francs. The next month the price is down to 1226 francs per ounce, so you pay 245,200 francs.
In this case, making the investment using unit cost averaging worked out cheaper at an average of 1232,8 francs per fine ounce (1,232,800 francs in total) compared to the original going rate of 1235 francs per fine ounce (1,235,000 francs in total). If the price of gold fell by 10 francs per fine ounce over the year following the first purchase, you would lose: 2000 francs on your first tranche; 2,800 francs on your second tranche; 2000 francs on your third tranche; 800 francs on your fourth tranche; and 200 francs on your fifth tranche. In total, the value of your investment would decrease by 7800 francs – 2200 francs less than if you would have made the full investment in one go.
Because there is no sure way to know whether the value of an asset will increase or decrease, there is no sure way to know at which point you should invest in an asset. Unit cost averaging helps to counter the negative effects of buying ahead of a price dip by balancing them with the positive effects of buying ahead of a price increase.
See also: Cost averaging effect
More on this topic:
Stock broker comparison
