(Almost) Too Good to Be True: The Cost-Average Effect

Context: The idea for this meme came to me during the process of applying to a company active in the financial market. I remembered the time when, as a student, I was already searching for big money and believed I would find it at a financial distribution firm.

One of the sales arguments back then was the so-called Cost-Average Effect (in German: Durchschnittskosteneffekt, also referred to in English as dollar-averaging effect). This concept describes regular investments of fixed amounts into (volatile) securities, where price fluctuations lead to purchasing shares at a lower average price. When prices are high, fewer shares are bought; when prices are low, more shares are purchased, so that per share the harmonic mean rather than the arithmetic mean of prices is paid. Or put differently: price losses weigh less heavily because through regular purchases of shares, more shares are acquired during bad periods, allowing for stronger participation in future price gains. It therefore reduces the risk of loss of such investments - at least that is the theory.

This certainly seems coherent and intuitively plausible (which is why it is unfortunately used as a sales argument) — yet in reality, it turns out that investing larger lump sums is often associated with less risk than investing smaller amounts on a regular basis.¹

At this point, it should be noted that I find the term Effect highly misleading. It suggests that this is an empirical fact. However, the opposite is true: it is a theoretical concept that is not empirically sustainable.²

Nevertheless, it cannot be denied that this concept has persuaded many risk-averse individuals to start investing — almost like a lie that produces something good.