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Don't get fooled by the cost-average effect

I have a bit of money invested in stocks and funds, passively managed by my bank. I've made a bit with risky speculations, and I've lost about the same amount with the markets' dive of the last 18 months. Net benefit: zero cash, a bit of experience. Time to move on…

I am not an interesting customer, so I was all the more surprised to get a call from an employee of the bank the other day. He identified himself as "Crisis Manager" or something similarly ridiculous, mentioned at least 20 times that he was a regular employee and wouldn't receive provisions, and he also kept assuring me that he's doing himself what he's suggesting to me: leveraging the cost-average effect.

I turned him down, probably a bit too briskily. Let's investigate why.

Banks are good at devising ingenious tricks to fool people; it's their business after all. One of those tricks is the so-called cost-average effect. It's awesome, they say, because it is the first product that adapts to the ever-changing market: when prices are up, it buys smaller numbers of shares, and in low times, it stocks up on them by buying larger quantities, automatically.

Fancy, no? It isn't, because the entire idea is to get your signature on a contract that obliges you to pay a fixed sum each month, with which shares are then bought. Obviously, when prices are up, numbers you get for your money are low, and vice versa. Observe how well the banks manage to turn that basic rule into a selling point. They are good at that. In fact, that's probably all they're good at. "Obviously", inflation is also factored in, so the monthly "fixed sum" actually increases by a projected 5% each year, which they call "inflation protection".

While this strategy — investing fixed-sum installments rather than lump sums — certainly has its benefits, and can level out the risk of throwing a large sum of money at the market, it is commonly considered a suboptimal strategy, especially when employed over longer spans of time. For more information, I refer you to the frequently cited article "Nobody gains from dollar cost averaging — analytical, numerical and empirical results", published in the 1992/1993 issue of the Financial Services Review journal.

So why would the bank approach me with this "offer"? Let's go hypothetical and check out Ashley's investment practices:

Ashley bought a fund five years ago at 100€ per share, and it's now down to 80€. The loss is thus 20%, a -4% factor (20% / 5 years) that affects the overall performance of the portfolio.

Ashley doesn't really care much about the percentages. After all, the only thing that counts is the worth of the shares when sold right now. Everything else is history and only influences the size of the tears one weeps in times like this, which is a psychological malfunction, not a function of the financial markets' crisis.

The bank, however, does not like negative performance values.

Positive percentages yield happy (blinded?) customers, who get much more enthusiastic (greedy?) to put more money into the giant machine that makes the banks tick — which is still in the process of blowing up into their faces.

But negative performance values cause investors to become conservative and leery. They'd rather hold on to their hard-earned cash for fear of losing more. That's the flip-side of aforementioned psychological malfunction, and this is the core of the reason why some of the big investors get bigger even in times like this — they do not succomb to the "feeling".

The banks, however, need cash, and loads of it, and while the state is busy printing notes, they take every chance to get more. Private clients are wonderful prey, as they are less informed about the system than investors. So, to get cash from the clients, the banks have to circumvent the psychological malfunction.

They cannot boost the market value share, but there are two values that factor into a percentage, and the cost-average effect, sold as the best thing since sliced bread, is nothing but a way to affect the other number: the sale price, the divisor.

If the fund stays below the original sale price (100€), each time Ashley pumps more cash into the machinery each month, this divisor decreases, effectively decreasing the percentage value. In the long run, this yields happier customers, who are willing to put more money in, especially if the performance turns positive. The baseline is now lower, so a return to previous heights would correspond to larger performance values than ever before.

Obviously, a positive market causes the baseline to grow, but the cost-average deals continues to pay off for the banks. Since Ashley put that signature on the contract, the bank has a guaranteed cash flow for the contract's duration, while Ashley wonders why the percentage remains dampened. Cost-average means decreasing the percentage, in good as well as in bad times. Just now, the bank doesn't have to work so hard to get even more money from you.

It gets worse: usually, those contracts are embedded in some sort of life insurance deals with grand promises in 40 years to come, and over all that time, it'll be quite clear who wins and who loses.

Scary, huh? I was going to end with the advice to stay away from the cost-average effect, but I think I can just as well make it more general: if you don't understand a deal, don't sign it. If you abide by that rule, you would stay away from cost-average effect deals all by yourself.

Maybe my little writeup has helped, nonetheless.

NP: DJ Tiësto: Live at Innercity