How to Use Price Averaging

When I worked for a financial institution, I met too many investors who allocated funds to an investment once and waited for it to grow. The same investors have a full-time job and get paid on a weekly, bi-weekly or monthly basis. I advised them to allocate a lump sum at first and contribute a portion of their salary. Many didn’t understand the benefits of spreading their money over periodic investments instead of dumping it once a year. This article will explain these benefits for stocks and funds (mutual funds & ETFs). We’ll concentrate on dollar-cost averaging and value averaging. This is also known as price averaging. Finally, we will also briefly explore how to average with dividends. Let’s begin.

Stocks vs Funds Averaging

Price Averaging

To begin with, the major difference between purchasing stocks and funds is commission fees. 

What else does that mean for other types of investments and price averaging?

Price Averaging With Mutual Funds

When investors purchase mutual funds, there are no commission fees per trade. There is only a management fee and an expense ratio. They will range between 1-3%.

This depends on how actively managed is the fund and how much the fund manager is paid. When there is a high turnover, securities within the fund are bought and sold more frequently.

This is an example of an actively managed fund. On the other hand, passively managed funds have a lower turnover and hence lower fees.

Mutual funds may take a bite out of your earnings, but they don’t charge a fee every time you make a purchase. And this can help with price averaging.

Price Averaging With ETFs and Stocks

Now, let’s talk about price averaging with ETFs and stocks. I grouped them together because they both charge commission fees at the moment of the purchase. ETFs also charge a management and expense ratio, but it is usually between 0-1%.

Oftentimes, it will be even lower than 0.5%. Investors who wish to periodically purchase ETFs and stocks have to put the fees into consideration. When the periodic amounts reach thousands of dollars, the fees are negligible. However, for those making much smaller purchases, those fees amount to a significant percentage of the transaction. 

Price averaging becomes more complicated for investors who want to access more performing investments such as stocks. To minimize fees, it’s important to choose the right broker.

Which Broker is Best for Mutual Funds, ETFs and Stocks

Price Averaging

As we mentioned earlier, mutual funds don’t have commission fees. Before the pandemic, many major financial institutions and brokers charged fees.

After the recent boom and interest in meme stocks and new sectors, many institutions realized the value of removing commission fees. They realized it was better to keep their existing clients and portfolios rather than to charge fees and risk their departure for a competitor. 

Which domestic brokers and financial institutions are the best for stocks, ETFs and mutual funds? TD Ameritrade probably offers one of the best services. There are no fees on US stocks listed on NASDAQ and NYSE as well as ETFs.

The same applies to Charles Schwab, Fidelity and Vanguard. However, they will not offer commission-free trading for stocks and funds outside the US.

To have access to international stocks, funds, markets, commodities and digital coins, eToro and Plus500 offer great value for almost no fees. Which is helpful for price averaging.

Dollar-Cost Averaging vs Value Averaging

As I mentioned in the opening paragraph, it’s better to begin your investment with a lump sum and to add periodically. One of the easiest ways is during pay day. This usually happens on a weekly, bi-weekly or monthly basis.

The best course of action is to subtract all your expenses from the periodic salary and allocate a portion for long-term investments. The remainder goes for personal purchases, entertainment, projects and savings. 

Both can be applied to stocks and funds with price averaging. Personally, I recommend splitting your investments to promote diversification. There are two major techniques for investors to do so.

Dollar-Cost Averaging

The first one is the easiest of the price averaging. Dollar-cost average consists in putting the same amount of money into the chosen investment. Suppose it’s $200 every two weeks into ETF ABC.

This allows the investor to spread the risk across time. When the price drops, more units are purchased. They are worth more when the price goes back up.

We can look at the table below for a fictional example. When the price of the fund drops to $9.90, more units are bought. They are worth more when the price increases. 

 ABC Fund PriceContributionUnits BoughtUnits OwnedTotal Value
Pay 1$10.00$2002020$200
Pay 2$9.90$20020.240.2$397.98
Pay 3$10.50$20019.0459.24$622.02
Pay 4$10.70$20018.6977.93$833.85
Pay 5$11.00$20018.1896.11$1,057.21
 Dollar-Cost AverageTotal ContributionTotal Units BoughtInvestment ValueProfit/Loss
 $10.42$1,00096.11$1,057.21$57.21

For those who work for a public company, there is often a feature offered for stock purchases. A portion of the pay goes into the company’s stock. When I worked for a financial institution, the percentage was capped at 10% of my pay.

Some companies will even match the amount to a ceiling. This amount can be invested in a cash account or a retirement plan(401k or IRA, RRSP for Canadians). Dollar-Cost averaging can be set up directly with your broker, or it can be done manually.

Value Averaging

The second price averaging option implies one small change. With value investing, the periodic amounts change. The amount bought depends on the current market price and the value of your investments. When the price drops, the amount invested increases. When the price increases, the amount drops. Let’s look at an example with ETF DEF.

 DEF Fund PriceAmount RequiredAmount InvestedUnits BoughtUnits Owned
Pay 1$10.00$200$2002020
Pay 2$9.90$400$20220.440.4
Pay 3$10.50$600$175.8016.7457.14
Pay 4$10.70$800$188.6017.6374.77
Pay 5$11.00$1,000$177.5316.1490.91
 Dollar-Cost AverageTotal ContributionTotal Units BoughtInvestment ValueProfit/Loss
 $10.38$94490.91$1,000.00$56.00

In this case, the amount contributed is less only $944, but the real amount of the investment is $1,000. In this case, the price kept increasing, hence the number of units bought didn’t increase.

The profit in this example is slightly lower, but the amount invested is significantly lower. The return is better with a value averaging strategy. This averaging method must be done manually and requires some basic math skills or an excel spreadsheet.

Dollar-Cost Average total contribution = Value Average investment value

Bonus: Buying the Dip

Price Averaging

Here is a term many financial experts praise. How does it work? When the stock market experiences a particularly bad period, it’s time to buy the stock or funds on your watchlist.

The reasoning behind this is simple. The downfall of the market is due to externalities that are unrelated to the performance of the investments in question. T

he market drops because there is uncertainty due to an international event. 

Buying the dip isn’t always a good thing. When the event is specific to an industry, it might be hard for it to recover. We always have to ask ourselves who and what does the externality affect?

If it’s just a scare, buying the dip is a good option. If it will have consequences that will unravel in a few months, maybe it’s time to invest in safer assets. 

In 2020, a pandemic hit us. The stock market dropped drastically in March, but by April began an impressive bull run. Many experts warned that the stock market isn’t an indicator of the economy and that repercussions of the pandemic will be felt down the road.

Fast forward to today, we are dealing with inflation and chain supply issues. Yes, the war in Ukraine isn’t helping, but the pandemic caused many issues that are only felt economically today.

Price Averaging With Dividends

In this final section, we will briefly go over what is called a Dividend Reinvestment Plan (DRIP). Dividends can be settled as cash, or reinvested back into the fund or stock. Fractional units of a fund are permitted.

However, not every broker allows the ownership of fractional stocks. Dividends are usually distributed quarterly. A DRIP can be setup automatically with your broker. When the stock or fund distributes dividends, they are automatically reinvested. 

Now You Know What Price Averaging Is

To conclude, price averaging is a simple technique used by investors of all levels. It allows spreading the risk of a security over time. It can easily be done on pay day. There are two ways to price average: dollar-cost averaging and value averaging.

The first is much simpler and can be set up with your broker. The second requires manual contributions and some basic math skills. Value averaging has been gaining more popularity and provides better results in the long term. It is definitely worth taking a look at. 

If you want to learn more about how you can profit from the stock market, head on over to our free library of educational courses. We have something for everyone, including trading options for those with small accounts.  

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