Unit cost averaging

Unit cost averaging is a method of timing purchases to reduce the exposure to fluctuations in the price of the security being purchased. It is also called pound cost averaging, dollar cost averaging etc.

An investor using cost averaging splits a purchase of a security into several tranches which are bought at different times. This has the benefit of smoothing out the effects of short term fluctuations in the share price.

The price that is finally paid will tend to be closer to the bottom end of the range in which purchases were made than to the top end. To see the reason for this consider a simple example.

An investor spends £2,000 buying shares in two tranches of £1,000. The first purchase of 1,000 shares at 100p. The price then falls and the next purchase is of 2,000 shares at 50p. The average price paid is £2,000 ÷ 3,000 = 67p. This is less than the average of 100p and 50p.

Unless the price is likely to fluctuate wildly, any gains from cost averaging are likely to be outweighed by the additional costs of trading this way.

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