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Does Pound-Cost Averaging Out of a Position Make Sense?

The method used to purchase stock might not be your best bet when selling

Adam Zoll 14 January, 2013 | 6:00AM

Question: 

I own a large holding of my employer's company stock and would like to sell out of it and diversify. Would I be better off pound-cost averaging out of the position or selling it all in a lump sum?

Answer: 

Many financial pros recommend pound-cost averaging when buying into a position, but it can be counterproductive when selling, as we'll see in a moment. First, let's review how pound-cost averaging, or PCA, works. In conventional PCA, shares are purchased at regular intervals and in fixed pound amounts over a period of time. One of the benefits of PCA is that it causes the investor to buy more shares when prices are low and fewer when they are high. PCA also reduces the volatility experienced by the investor and helps the investor avoid the temptation of trying to time the market by finding the right moment to invest a large sum all at once.

As discussed in this recent Short Answer column, a Vanguard study found that over long time periods PCA usually produces slightly lower returns than investing money immediately in a lump sum due to the fact that the market's long-term trajectory generally is up. Therefore, holding some money out of the market through PCA gives it less time to grow compared with investing the entire sum all at once. (Although lump-sum purchasing generally outperforms PCA, that might not be true in every case.) 

Throwing PCA Into Reverse

But what if you are trying to sell out of a position rather than buy into one? It stands to reason that one of the main benefits of pound-cost averaging into a position--buying more shares when prices are low and fewer when they are high--becomes a negative when selling out of a position, sometimes referred to as reverse pound-cost averaging. In other words, selling out of a position in equal amounts and at regular intervals would mean selling more shares when prices are low and fewer when they are high--exactly the opposite of what investors want. The only advantages that would be preserved from conventional PCA are that reverse PCA would provide a disciplined framework for selling the position, thereby helping the investor avoid the temptation to time the market. So instead of selling out of the entire position all at once only to see the share price climb sharply the next day, you would be stretching out the sale over a longer time frame and reducing volatility.

Even a lump-sum sale isn't necessarily a clear-cut proposition. If you sell all your shares of stock immediately, you risk losing out on any gains that may occur later. Wait and do a lump-sum sale later, and you risk seeing your stock holdings lose value should the company hit a bump in the road.

Diversification a More Important and Urgent Goal

However, rather than dwell on the question of whether reverse pound-cost averaging or a lump-sum sale out of a position puts you ahead or behind in terms of your final cash amount, consider the reason you are selling in the first place. Your goal of diversifying your portfolio is more important than the question of how you sell off some of your holdings, and it might be worth an immediate lump-sum sale in order to get there sooner rather than later.

Daniel Wallick, a principal at Vanguard who worked on the firm's PCA study, says the importance of diversifying a portfolio that includes a large position in a single stock trumps concerns about reverse PCA. "The diversification benefit is almost the primary function you want to solve rather than worrying about market direction," he says.

"Let's say you had all your money in Coca-Cola (KO). It's been a great run, you've done really well, but there's also downside risk," Wallick says. "There's a strategic asset allocation based on your risk tolerance and financial objective. Once you've identified that, if diversification is the right answer for you, probably getting there as quickly as possible makes the most sense."

Wallick cautions that investment-related costs such as taxes and sales charges also should be factored into the equation. For example, if selling out of a position 1/10 at a time will cost you 10 times as much in brokerage commissions as selling in a lump sum, that needs to be taken into consideration.

For Funds, Answer May Differ

The same logic that argues for diversifying quickly out of a large single-stock holding might not necessarily hold true for a mutual fund that dominates your portfolio. A single fund may own shares in thousands of companies and provide adequate diversification across sectors and geographic areas. However, if selling out of a large holding in a highly concentrated fund or any fund you need to sell in order to adjust your portfolio's allocation quickly--such as rebalancing from an equity-heavy allocation to one more in line with your risk profile--the lump-sum approach allows you to reach your goal sooner than reverse PCA will.

The Bottom Line

Using reverse PCA to rebalance your portfolio or as a way to gradually convert an investment to cash might still make sense if it makes you more comfortable than selling in a lump sum. But you'll have to weigh that benefit against the potential for reduced returns, added costs, and prolonging your investment objective.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Coca-Cola Co41.27 USD1.61
About Author

Adam Zoll  is an assistant site editor with Morningstar.com, the sister site of Morningstar.co.uk.