Testing a river with both feet is never a good idea. But when stocks are down to their lowest in years, it is very hard to resist jumping on cheap valuation.
The stock market last week saw record declines with investors losing close to N2 trillion in four trading days, that has turned out to be the worst on NSE in four years.
The spread of the Coronavirus and massive drop in oil price perplexed the market as price of stocks like MTN Nigeria, Guaranty Trust Bank and Nestle, among others fell to new lows that seem to signal significant capital gains whenever positive news on the Coronavirus or oil market is announced.
With the direction of the market still uncertain despite Friday’s marginal gain, naira-cost averaging would be a great strategy to help minimize risks when taking position in cheap but fundamentally sound stocks.
Cost averaging simply means buying a fixed amount of shares periodically, thus reduces the effect of swing in price over time.
The advantage of naira-cost averaging (typically referred to as dollar cost-averaging or constant dollar plan) is that it prevent investors from jumping into the market at a wrong time.
How naira cost averaging works
Let’s assume you are an investor that want to invest in company Anticorona which a very erratic stock price.
Let assume you want to invest naira average N100,000 by investing the same fixed amount for the next five months.
The chart below shows the stock price in each of those five months and how many units you were able to purchase based on that price.
From the table you can see that spending N20,ooo on anticorona stock regardless of price will result in a total units of 12,912.698 and an average share price for you at the end of five months.
Without cost averaging, you would have spent N100,000 to buy 10,000 units at N10 per share which is lower than using cost averaging by almost 3,000 units.
While price has fallen to as low as N6, the 12,912.698 units will be worth N77,476.188 but when you compare the return on 10,ooo units (without averaging) you would get a portfolio value of N60,000.
Both positions have yielded a loss (given our pessimist example of consistently falling share price) but cost averaging clearly preserves value better, with the investment N17,476 higher than when one just jumps into the market.
For investors seeking to take advantage of currently low price on the Nigerian Stock Exchange (NSE), this strategy could result in even higher return when current pressure on stock on the back of oil decline and the Coronavirus ease.
Some stocks have delivered good results in 2019 despite challenging operating environment while others have very attractive dividend yield. This means investors would be looking to position in those stocks as soon as positive developments emerge.
While cost averaging might sound exciting, it is only useful when there is high volatility in the market especially in a downward spiralling one.
Investors can find themselves with a lower return than they invested at once if the market is steadily gaining over a period.