What Is Adjusted Average Cost Effect?
The Adjusted Average Cost Effect describes a psychological phenomenon within behavioral finance where investors subconsciously alter their perception of an investment's average cost, often diverging from the actual, calculated cost basis. This mental "adjustment" is typically influenced by factors such as recent market movements, the initial purchase price, or the emotional impact of gains and losses, rather than purely rational financial data. This effect can lead individuals to make decisions that deviate from a purely objective investment strategy, impacting their portfolio performance.
History and Origin
While not a formally codified term with a singular origin, the principles underlying the Adjusted Average Cost Effect are deeply rooted in the broader field of behavioral finance. This academic discipline emerged to explain why investors often act irrationally, contradicting traditional economic theories that assume perfectly rational decision-making29, 30. Pioneering work by psychologists Daniel Kahneman and Amos Tversky in the 1970s laid much of the groundwork, particularly their development of Prospect Theory, which demonstrated that individuals evaluate potential outcomes in terms of gains and losses from a reference point, rather than in terms of final wealth28.
Concepts such as loss aversion (the tendency to feel the pain of losses more intensely than the pleasure of equivalent gains) and the disposition effect (the inclination to sell winning investments too early and hold onto losing ones too long) are closely related to how an investor might perceive or "adjust" their average cost26, 27. For instance, Terrance Odean's 1998 paper, "Are Investors Reluctant to Realize Their Losses?", provided empirical evidence of the disposition effect among individual investors, showing how the psychological discomfort of realizing a loss often leads to holding onto underperforming assets22, 23, 24, 25. This reluctance can implicitly "adjust" an investor's internal average cost, as they may view a declining asset as still "costing" them its higher initial purchase price, even as its market value falls.
Key Takeaways
- The Adjusted Average Cost Effect is a behavioral phenomenon where an investor's perceived average cost of an asset deviates from its actual, calculated cost basis.
- It stems from cognitive biases such as anchoring to initial purchase prices and loss aversion.
- This effect can lead to suboptimal decision-making, such as holding onto losing investments longer than warranted or making irrational new purchases.
- Understanding this bias can help investors implement strategies to promote more rational financial behavior.
Interpreting the Adjusted Average Cost Effect
The Adjusted Average Cost Effect highlights the disconnect between an investor's rational financial calculations and their emotional or intuitive understanding of their investment costs. When an investor experiences this effect, they might interpret their "average cost" in a way that aligns with their emotional state or a psychological anchor, rather than the true average. For example, if an investor bought shares at $100, then bought more at $50, their calculated average cost is $75. However, if the stock is now at $60, they might still feel as if their "average cost" is closer to $100 (due to anchoring to the initial higher price), especially if they're experiencing discomfort from a paper loss. Conversely, if the stock rose to $120, they might feel their "average cost" is even lower than $75, emboldening them to take more risk.
This skewed perception can influence actions in the financial markets. Recognizing the Adjusted Average Cost Effect means understanding that personal biases can override factual data. It suggests that merely knowing the numerical average cost is not always enough to drive rational decisions, as deeper psychological influences are at play. Investors aiming for improved outcomes often need to actively counteract these innate biases to align their perceived cost with their calculated cost basis.
Hypothetical Example
Consider an investor, Alex, who decided to buy shares in "TechCo Inc." Alex's initial purchase was 100 shares at $100 per share, for a total of $10,000. Over the next few months, TechCo's price declined due to market volatility. When the price dropped to $50 per share, Alex decided to buy another 100 shares, spending an additional $5,000.
Alex's total investment is $15,000 for 200 shares. The actual, calculated average cost is $15,000 / 200 shares = $75 per share.
However, Alex might experience the Adjusted Average Cost Effect. When the stock recovers slightly to $60 per share, Alex's portfolio value is $12,000 (200 shares * $60). Despite the calculated average cost being $75, Alex might still feel "down" on the investment, mentally anchoring to the initial $100 purchase price. The perceived average cost might feel higher, perhaps closer to $80 or $90, because of the lingering memory of the initial, larger investment amount and the associated feeling of a loss. This could lead Alex to hold the shares longer than a rational analysis would suggest, hoping to "get back to even" at the original $100 price, even if other opportunities arise that offer better prospects for recovery. This behavioral tendency illustrates how emotional factors can subtly adjust an investor's internal reference points, impacting their subsequent actions.
Practical Applications
The Adjusted Average Cost Effect primarily manifests in how investors approach their existing positions and future trading decisions. In real-world investing, this behavioral tendency can influence decisions related to selling, buying more, or holding assets. For instance, an investor swayed by the Adjusted Average Cost Effect might resist realizing a capital loss on a stock that has fallen significantly below its initial purchase price, even if its fundamentals have deteriorated. This often occurs because the investor's mental "average cost" is anchored to the higher entry point, making them reluctant to "lock in" the perceived loss, a manifestation of loss aversion20, 21. This behavior is frequently observed during market downturns, when negative investor sentiment can exacerbate such biases15, 16, 17, 18, 19.
Conversely, investors might also become overly confident or conservative based on their mentally "adjusted" average cost. For example, if an investment has performed well, the investor might perceive their average cost as even lower than it actually is, leading to an inflated sense of gain and potentially fostering overconfidence in their stock-picking abilities14. This can lead to excessive risk-taking or an unwillingness to diversify, even when prudent diversification suggests rebalancing the portfolio. To mitigate the impact of such biases, many financial professionals recommend adhering to a disciplined strategy, such as setting predetermined exit points for gains and losses, irrespective of perceived costs or emotions. Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) emphasize the importance of understanding cost basis for tax purposes, underscoring the need for objective record-keeping over subjective perception13.
Limitations and Criticisms
The primary limitation of the Adjusted Average Cost Effect, and behavioral finance phenomena in general, is that it describes a tendency, not a deterministic rule. Not all investors exhibit the same degree of this bias, and its impact can vary based on an individual's personality, experience, and the specific market conditions. Critics of behavioral finance sometimes argue that while these cognitive biases exist, they may not consistently influence financial markets on a macro level, as rational arbitrageurs might correct mispricings.
However, ample research suggests that individual investor behavior, often influenced by perceptions such as the Adjusted Average Cost Effect, can indeed lead to suboptimal outcomes, including underperformance compared to simple benchmarks12. For instance, despite academic evidence demonstrating its mean-variance inefficiency in normal circumstances, dollar-cost averaging remains a popular strategy, partly explained by a cognitive error where investors are convinced that buying at a lower average cost must increase profits, even though this doesn't guarantee higher returns8, 9, 10, 11. This highlights how the perceived benefit (a "lower" average cost) can override a purely rational assessment of investment efficiency. The challenge lies in overcoming these deeply ingrained psychological tendencies, which can be difficult even when an investor is aware of the bias.
Adjusted Average Cost Effect vs. Average Cost Basis
The "Adjusted Average Cost Effect" is a behavioral concept, describing how an investor perceives their average cost, often influenced by emotions and biases. It refers to a subjective, internal reference point.
In contrast, "Average Cost Basis" is a tax accounting method used to calculate the official cost basis of an investment for tax implications when multiple purchases of the same security have been made at different prices6, 7. This method involves averaging the total cost of all shares by the total number of shares to arrive at a single average cost per share. It is a precise, verifiable calculation used for determining capital gains or losses upon sale, as outlined by tax authorities like the Internal Revenue Service (IRS) in Publication 5512, 3, 4, 5.
The confusion between the two arises because both involve an "average cost." However, the Adjusted Average Cost Effect refers to a mental distortion of this average, whereas Average Cost Basis is a factual, regulatory calculation. An investor might employ the Average Cost Basis method for tax reporting while simultaneously being influenced by the Adjusted Average Cost Effect in their investment decisions. The former is a mathematical procedure for compliance, while the latter is a psychological bias impacting decision-making.
FAQs
Why do investors mentally "adjust" their average cost?
Investors mentally "adjust" their average cost due to cognitive biases. This can include anchoring to a memorable price (like a high initial purchase price) or the emotional impact of gains and losses, making their perceived cost differ from the true calculated cost basis.
How does the Adjusted Average Cost Effect influence investment decisions?
The Adjusted Average Cost Effect can lead to suboptimal decisions. For instance, it might cause an investor to hold onto losing investments longer than they should, hoping to "get back to even" with a perceived higher cost, or to take on too much risk if they feel their perceived average cost is very low, even if this is an illusion.
Can this effect be completely avoided?
Completely avoiding psychological biases in investing is challenging for most individuals. However, investors can mitigate the impact of the Adjusted Average Cost Effect by adopting disciplined investment strategy approaches, such as setting clear rules for buying and selling, focusing on long-term goals, and relying on factual cost basis calculations rather than emotional perceptions. Resources like the Bogleheads philosophy emphasize a systematic, low-cost approach to investing that aims to reduce the influence of behavioral biases1.