Cost-Average Effect - How To Succeed with Buy & Hold Strategy

THE EASIEST WAY TO SUCCEED ON THE STOCK EXCHANGE

The easiest way to have success on the stock exchanges is to buy and hold the index. You don’t need to create portfolios, think about which stocks to invest in, just buy and hold the index. You know about long-bias on the stock market plus the average yearly return is about 10% (non inflation adjusted) for the last 100 years (history of the Composite Index, the predecessor of S&P 500). 

Since 2010, it is very hard to beat the main US stock indices with your own portfolios. For the investor, the most important thing is to buy low and sell high in the long term. Well, we never know if we are on the top or on the bottom. Let’s talk a little bit about the timing in this article.

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Timing the entry of your investment

The best timing to invest is straight after the drawdowns. You can set some basic rules if the market falls more than 5% in a short time and there is no major fundamental reason, you can buy.

By fundamental reasons, I mean financial crisis 2008 or covid-19 pandemics in 2020. If there is some big event affecting the market for a longer time, that is the best opportunity to invest. I believe you have read in many investment books, the best time for long-term investments is when there is absolute despair in the market.

But that is kinda risky, too. You don’t know if after the mayor drops, the market will not fall another 15%. And you don’t want to go to the drawdown straight after the investment. One of the answers could be cost averaging. 

Idea of cost-average

The idea is simple – imagine you were waiting for a major event, and you have prepared 100K of USD to invest. Instead of investing all in one moment, spread your investment into 3 to 10 consequent buys and buy every week, or differently, depending on the fundamental event and your opinion on how long it could last. 

 

The final buy price will be averaged through the time, in some cases you possibly caught the bottom and in others not. The major stock drops like the dot-com bubble and financial crisis 2008 are great examples of cost-averaging. 

 

The stock crash of 2020 and the subsequent recovery was so fast that you were not able to make more buys while the prices were lower. You just have to set some basic rules, like wait until the market crashes 30-40%, then when seeing some recovery, you can start with cost-averaging (you don’t know if it will continue falling more at that point). 

 

This was my tactic for the 2020 crash, but as we know, it was super fast, and the other purchases were more costly than the first one. The stock market is dynamic, and we never know when there will be a major trend change, and it is also possible that after the major drop, the market will continue falling for a few subsequent years. 

 

There are many examples in history, just look at the S&P 500 historical plot of the last 100 years. On the plot, there are major recessions as grey regions. Just for comparison of long-term investment, we look at inflation-adjusted prices (for the real long term, it is important to count also the inflation). 

 

Not inflation adjusted S&P 500 plot (not readable)

sp500_100y_nonadjusted

Not inflation adjusted S&P 500 plot, log-scaled (for better readability)

sp500_100y_adjusted

From historical prices, we can see that there were a few periods without uptrend. Most visible is the Great Depression, which started in 1929 and the market was falling until 1931, then the Second World War period, and the whole decade of stagnation 70s (thanks to the oscillation of the financial market, the inflation adjusted prices dropped significantly, see another plot). In the 2000s, we experienced two significant market drops.

Inflation adjusted prices of S&P 500, log-scaled

Example of cost-average

Let’s look at an example of cost-average after the financial crisis in 2008. This is only for example purposes, all of us have a huge look-ahead bias when analyzing this situation. 

Let’s invest in the Nasdaq 100 ETF, QQQ. Truly we don’t know when the selloff will finish, so let’s consider a 40% drop and subsequent bounce from the bottom as the starting point. 

We are in Oct 2008, let’s have 10 purchases each week. We will compare different starts. Let’s say some investors began to invest at the beginning of November, after a significant bounce. You started some random date during that week and invested 10 times with one week difference between the purchases. The price continued to drop, so let’s make 15 investors, each started some random day with 1 week lag. 

We can see that almost every investor got the average value between 29-30 (while the bottom was near 26 but hard to catch). The last investor who started at the end of February got a bit worse average price of 30.7. 

On the plot, you can see horizontal lines as average prices during the invested period for each investor, on the legend is the starting date for each investor. 10 purchases each week is roughly two and half months of investing. Depending on the amount of invested capital, I would not go for more than 5 purchases. You can improve this idea by investing only the days when the price dropped to get a better average price. The important here is the idea of averaging the price for lowering the risk.

No one got the bottom price of 26, but according to the growth which continued after, it is more important to be in the market in the right direction than greedily catching all possible profits (the greediness can also delete your account).

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