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MONEY MANAGEMENT
Zero Cost Averaging
by Terrence M. Quinn and Kristin A. Quinn
This technique steps in to assist in the management of the investment after the investor has determined which securities to purchase and when to open the position.
Traditionally, fundamental analysis and technical analysis have been used to evaluate stocks, mutual funds and other equity securities. With technical analysis, the focus is upon the tradable instrument's actual price movement in the marketplace, as opposed to fundamental analysis, whereby the company's earnings potential is examined and the trading instrument's performance in the marketplace is not analyzed. Based on price patterns, technicians endeavor to determine when it is the best time to buy (or sell) the security.
There is a third form of security analysis, known as zero cost averaging (ZCA). ZCA's objective is to assist the investor in answering the question of how to invest in the stock, mutual fund or other security. Zero cost averaging does not replace either fundamental or technical analysis; rather, ZCA works with other analytical methods. Once the investor has determined what securities to purchase and when is a good time to open the position, ZCA steps in to assist in the management of the investment.
To grasp the significance of how to invest, consider the skills needed to be a good card player. Whether the game is bridge, gin rummy or poker, the strength of the hands dealt to each player will be about the same over the long run. Consequently, the difference between a good player and a poor player depends on how each plays his hand. Similarly, the difference between a good investor and a poor one often boils down to how each manages his/her investments.
Most investors pay little attention to the management of their investments. The tendency is to purchase their shares in a stock or fund all at once, with no thought given as to when to sell. If they do decide to sell at some later date, usually all of the shares are disposed of in a single transaction. Seldom do investors attempt to adjust their holdings in any strategic manner.
It is this void that ZCA is designed to fill. The purpose of zero cost averaging is to provide investors with a systematic approach to the management of their investments.
ZCA OBJECTIVE
Suppose an investor bought 300 shares of a stock at $20 per share. About a year later, he notices that the stock price has risen to $30 per share. What does he do? This question has many possible answers, none right or wrong. An investor who prefers buy-and-hold will look at this situation and, true to form, do nothing. He will be pleased that his $6,000 investment has now increased to $9,000, but he bought the stock intending to hold onto it and that is what he will do.
A trader, on the other hand, is likely to look at the 50% profit represented by the increased stock price and decide to sell all of his 300 shares. Still another approach favored by some investors is to buy more. After all, if the stock has gone from $20 to $30 per share, momentum is on your side.
With each investment, the objective under a ZCA strategy is to eventually own a certain number of shares of the security at a zero cost in terms of cash flow.
Terrence M. Quinn, 900 Ridge Road, Suite R, Munster, IN 46321, is an attorney and financial consultant with Roney & Co. Kristin A. Quinn is a junior at the University of Notre Dame majoring in finance and Spanish.Excerpted from an article originally published in the April 1998 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 1998, Technical Analysis, Inc.