COST AVERAGING

This is not a type of money management in the pure sense of theword. Nonetheless, this is the most logical place in the book to fit itin. Cost averaging is mainly popular in the stock and mutual fund industry.It is not nearly as popular with traders in leveraged instrumentsand there is a reason for that. Cost averaging is also not a puremoney management method simply because the decision to cost averageis directly related to market action. Further, it is more concernedwith where to get into a particular market than it is about how muchto risk. As mentioned earlier, money management in the truest senseis completely unrelated to where to get in and where to get out of themarkets.The simplest definition to cost averaging is to add onto a losingposition. There are exceptions, but this is the most common use of themethod. For example Joe Trader invests $5,000 in a mutual fund at$17.00 per share. Most mutual funds allow fractional shares andtherefore Joe Trader has 294.11 shares (provided there is no load). Astime moves along (as it normally does), the price of the mutual fundslowly drops. Several months later, Joe Trader decides to invest anadditional $5,000 into the fund at $14.80 per share. Because of thedrop in price, Joe is able to purchase 337.83 shares of the fund withthe second $5,000 investment. Joe now owns 631.94 shares of thismutual fund at an average cost of $15.82. Joe’s average price for eachshare of the mutual fund dropped from the original price of $17.00down to $15.82. Thus, the price of the mutual fund does not have tomove back up to $17.00 for Joe to recoup the losses from the initial$5,000 investment, it only has to move up to $15.82.$15.82 avg. price x 631.94 shares = $9,997.29(if we carry the decimals further it will total $10,000)$10,000 total investedl631.94 total shares = $15.8242 avg. share priceThis can go on for a considerable time. If the share price of thefund continues to drop, Joe may have a plan to invest an additional24 TYPES OF MONEY MANAGEMENT COST AVERAGING 25$1,000 for every $.50 the price drops from $14.80. If the price dropsto $12.00 per share, Joe will have invested as follows:$1,000 at $14.30 p/s = 69.93 shares Total shares = 701.87$1,000 at $13.80 p/s = 72.46 shares Total shares = 774.33$1,000 at $13.30 p/s = 75.19 shares Total shares = 849.52$1,000 at $12.80 p/s = 78.13 shares Total shares = 927.65$1,000 at $12.30 p/s = 81.30 shares Total shares = 1,008.95Joe now has $15,000 invested in this fund at an average cost of$14.87 per share. For Joe to recoup the losses, the fund has to moveup to $14.87 per share. If the fund moves all the way back up to$17.00, then Joe will have profits of $2,152.15, or a 14.34 percentgain on his investment. If Joe did not cost average, the investmentwould simply be a breakeven.There is a time and place for cost averaging. That time and placeis when the investor does not have to liquidate. This is exactly why itis not popular in the leveraged instrument arena. Joe never has tocome up with more money to be able to hang onto the mutual fund.However, if Joe decides to buy coffee at $1.10, Joe does not have toput up $41,250 to do so. (This is the total price of a coffee contract at$1.10 per pound with a minimum 37,500-pound purchase.) Joe onlyhas to put up the margin, which will probably be anywhere from$4,000 to $7,000 depending on the volatility.Using the same type of scenario as in the mutual fund, Joe invests$5,000 in coffee. With that $5,000, he is able to buy one contract.If coffee moves down to $1.00 and Joe takes another $5,000 tobuy an additional contract, he will have two contracts of coffee at anaverage cost of $1.05 per contract. However, he is losing a total of 10cents on the trade. Ten cents in coffee is $3,750 (.lO x 37,500). If coffeedrops another 10 cents, Joe will be losing 15 cents per contract, or30 cents total, which comes to a loss of $11,250 on a $10,000 investment.Obviously, Joe cannot take another $5,000 and invest it in anothercontract of coffee because the broker is going to want that andmore to maintain the current two positions. If Joe cannot immediatelyfund the account, the broker will liquidate and Joe will not onlyhave lost his $10,000, he will also owe an additional $1,125.A rule of thumb when trading leveraged instruments is, do notadd onto losing positions unless you will not have to liquidate.If played correctly, there are times that cost averaging can be utilizedin the futures arena. Back in April 1997, orange juice was tradingat $.68 per pound. Since the value of one contract in the orangejuice market is 15,000 pounds, the total value of the contract was only$10,200. For those of you not familiar with this market, the lowest orangejuice has been since 1970 is about 32 cents (early 1970s). Afterthe inflation boom in the late 1970s and early 1980s the lowest orangejuice reached was around 63 cents in early 1993. By late 1993, themarket had moved back up to the $1.30 level (a total value of $19,500per contract). I had done some research and determined that if orangejuice had traded at 32 cents back in the early 1970s the equivalentprice after a 2 percent annual inflation rate should be around 58 centsin April 1997. As a result, I was extremely confident that orange juicewould not go back to the 32-cent level then, and quite possibly never.Therefore, I decided that I should buy one contract for every $5,000 Iwas worth (even though margin was only around $800). I decided thiswith the intention of being able to continue to hold onto the positionseven if the bottom dropped out of the market and went below the58-cent inflation adjusted price level. And, if it went to 58 cents, I wasprepared to buy more (cost average) because I would not have to liquidate,even if I were wrong on the timing and the bottom. This is whenyou cost average in the futures market.There is actually a positive to cost averaging in the futures marketsin these situations over cost averaging in the stock market or mutualfund industry. The value of stock is based on the performance ofthe underlying company. Companies can go bankrupt. If you are costaveraging a stock and it goes bankrupt, you lose your entire investment.Or, stocks (as well as mutual fund companies) may drop, continueto drop, and never, ever move back to the levels at which youbought them. Commodities on the other hand, will never go to zerovalue. Will orange juice ever be free? Can it go bankrupt? Is the pricemovement dependent on human actions? The answers to these questionsare obviously no. I don’t care what farmers try to do, how muchthey try to grow or not grow, if a massive, prolonged freeze hitsFlorida in January, or Brazil in July, orange juice prices are going tomove, and they will move fast. In fact, since 1980, orange juice hasbeen below 80 cents four times. Each time (except for the most recentmove below 80 cents in April 1997), the price has bounced to over$1.30 within a two-year time period of hitting those lows. It tookabout lY2 years but in late 1998, orange juice hit $1.30! Had a fundmanager simply bought one contract of orange juice for every $5,00026 TYPES OF MONEY MANAGEMENT PYRAMIDING 27under management at each of these times and liquidated at $1.25,they would have an annualized return of, 18 percent for the past 18years with virtually no risk. A $5,000 investment would have grown toover $105,000! A total return of 2,100 percent:1980: Bought 1 orange juice contract at 80 cents.1981: Closed out at $1.25 for a $6,750 profit per contract.Account value = $11,675.1986: Bought 2 orange juice contracts at 80 cents.1986: Closed out at $1.25 for a $13,500 profit.Account value = $25,175.1993: Bought 5 orange juice contracts at 80 cents.1993: Closed out for a $33,750 profit.Account value = $58,925.1997: Bought 11 orange juice contracts at 80 cents.Current value = $1.08 for open profits of $46,200.Current account value = $105,125.One other rule of thumb about cost averaging before moving on.Never cost average a short sell! Cost averaging in commodities is basedon the fact that prices of anything cannot go below zero. With commodities,the closer to zero, the safer the investment. However, shortselling a market because you think the market cannot possibly go anyhigher is nothing short of trading suicide. Traders who sold silver at$10 an ounce back in 1979 will verify this.