This article was written by Lester Wills, an Australian Commentator, who has kindly given his permission for us to re-print it here in full. The article is addressed to financial planners and it gives some interesting insights into some of the dilemmas we face at this time. We asked if we could use this for another reason. It contains one of the best descriptions of Dollar Cost Averaging we have ever seen.
If I said, “falling markets were a good thing”, most people would question my sanity. I have previously mentioned how decisions concerning money are rarely rational and are usually emotive. Consequently, falling markets and the resultant decline in values is likely to elicit a highly emotive response.
It would be very hard to try and persuade a client that they should maintain an aggressive stance when all they can see is the value of their investments declining. If you try and explain that the person is in fact buying cheap assets, they may well reply that they should wait until the bottom and buy them even cheaper! This is presupposing that you or they can pick the bottom of course.
As I said in a previous article, “try guessing the turning point in the price of a share, multiplied by many thousands of trades, through numerous time zones and multiple markets and countless numbers of derivatives”. Predicting the weather is probably easier. But still, some will like to try.
For us lesser mortals, it is not even worth trying. Instead, we should consider the falling market a buying opportunity. Why? Because all my research has shown me that the stock market has an upward bias. This means that in the long term it is not unreasonable to expect positive returns despite a few bad years from time to time.
When the market goes down, it is an opportunity to buy the assets at a lower price than you would have paid previously. For an investor with a regular savings plan, this can be extremely beneficial. I have done some simple modelling to illustrate the point.
I set up a spreadsheet with 120 periods (representing 10 years of monthly unit prices). In the first section I started the unit price at $5.00 and then increased it by $0.25 every month. By the end of the last month it had reached $35.00. This represented the market rising in a straight line. As I am simply illustrating a principle I have not allowed for fees and charges etc.
Every month $100 was invested and units were purchased (simple Dollar Cost Averaging). In the first month 20 units were purchased, in the next, just over 19 extra units were purchased (same amount of money but more expensive units). By the last month the $100 purchased not quite three extra units. The total number of units purchased was approximately 787 with a “market value” of $27,645.
So far so good
The next section I started the units at $5.00 but then dropped the price by $0.25 each month until it reached $1.00 when I started increasing it by $0.25. Towards the end I increased the price by $0.50 a month so that by the end of the 120 months, the price was exactly the same as the first section, namely $35.00 The unit price in this section was never higher than the previous section, and only equalled it at the very beginning and the very end. The interesting thing was that the number of units purchased was 1959, which had a “market value” in excess of $68,000!
Some will say that I took the unit price down too far so I changed the model and only dropped the price down to $3.00. This investor purchased 1146 units “worth” over $40,000! They still made a greater profit than the steadily rising market, but not as much as when the price had fallen further.
What about if someone already had an amount invested prior to the movements depicted in the model. Easy, start each investor off with 2000 shares valued at $5.00 each. The investor in the market that declined and then recovered still outperformed the investor in the steadily rising market.
I then went back to starting investing in the first month from a zero balance, but this time I let the price drop to $3.00 and then let it rise at exactly the same rate as the steady market, i.e. $0.25 a month. This meant that it
never reached the heights of the steady market with a final price of $31.00 compared to the steady market final price of $35.00
Guess what?
The investor in the market that declined and then recovered was still ahead of the steady market investor! This was despite the fact that the end unit price was almost 12% lower.
Some will say the moves in the prices were too excessive, so I changed it to just $0.10 moves. Same result with the regular investor in the market that declines and recovers outperforming the investor in the steadily rising market.
What does this all mean? The model is very simplistic and does not allow for the vagaries of the markets. However the underlying principle is still valid.
For an investor who continues to invest on a regular basis, when the market recovers, they will reap the benefits of investing at substantially lower prices. But an investor who abandons a regular investment plan in a falling market can miss out on the opportunity of making some very significant returns down the track.
Principles in Practice
Lester’s article makes good sense but what about an investor with a lump sum to invest? We believe in using Dollar Cost Averaging for all investing – whether it’s a lump sum or a “drip –feed”/accumulation portfolio. An investment portfolio being established with a lump sum will, in most instances, require an allocation to shares. Our practice is to buy these investments over time. The time frame will vary according to the amount being invested and our view of the market. Our administration service allows for very effective Dollar Cost Averaging using various currencies and a wide range of generally wholesale investment opportunities. If currency switches are needed these are done as required. This further enhances the smoothing effect of regular purchases from a currency perspective as well.
If you are building an investment portfolio with regular contributions you will, in effect, be employing Dollar Cost Averaging. At times like this it’s natural to feel unsure about the wisdom of backing a seemingly “lame horse”. Try to remember the principles outlined in the article and, provided you are sure about the underlying quality of the assets, stick with your strategy even though prices are down.
The burning question about when to bale out of riskier, growth assets is a frequent one at present. There’s no easy, quick, sure-fired answer to this except to say that, if you have the capacity to hold these assets through a time like this, do that. If there are compelling reasons why you can’t – either personal or financial – then discuss this fully with us. It could be that some belt-tightening is needed at this time. Some investors have had to face the fact that a smaller portfolio is unable to continue paying income at levels possible in the past. It may be that some re-structuring is needed. There are options to choose from and we are here to help.
If you have over NZ$350,000 to invest and want truly impartial advice, contact us to find out how we can put your money to work to fund your important goals.
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