"Save little save often - dollar cost averaging works, if you stick to it"
(Paul Clitheroe - 'Ten Keys to Wealth', Penguin 2002)
How we humans react
The current investment environment is still dominated by negative sentiment. It continues to be fuelled by economic uncertainty, threats of terrorism and, of course, what the cabbie told us this morning. Accordingly, the bankruptcy-promoting concept of "Fear and Greed" continues to be consciously mismanaged by most of us. That is, we continue to buy at the top, and sell at the bottom.
Because of our emotions, we tend to greedily take on more risk than we should, by buying at the top of the market (because we know with certainty that the market will continue to go up) and ignore opportunities wherever we can by being too fearful to buy in when markets fall (because we know with certainty that the market will continue to fall).
Oddly, but understandably, Fear more so than Greed is currently the dominant emotion. However, is now when we need some Greed, albeit disciplined Greed? Should we consider buying at the bottom for a change?
Has there ever been a time where there hasn't been uncertainty? If this were the case, opportunities would never exist. Uncertainty (or risk) is what every investor lives with in the expectation of a reward. The trick is to minimise the risk associated with the level of your reward expectations, but without risk, there is generally no reward.
Now that equity markets are as close to "the bottom" as they probably have been in three years (see MSCI World Index chart later), it is probably fair to suggest that markets are less risky than they have been. Whereas uncertainty still exists, the corollary is that the opportunity to find high quality companies that are underpriced relative to their growth opportunities must be greater now than it has been for some time.
However, because of the experiences of the last three years, accumulated Fear has us all thinking about selling our shares, putting our money into cash, and/or buying real estate at the top of its market cycle.
This emotionally driven tactic suggests that we know for certain that markets will continue to fall. Because we have such perfect information, we sensibly feel that we should seek to make up any losses already suffered, by selling the under valued shares, keeping the proceeds in cash (which provides interest and no capital growth) or buy property which is over valued because we know with certainty that it will continue to go up in value.
Given that most of us are human and that because we are experts in the gentle art of Fear and Greed, we tend to continually and consciously mistime our investment decisions in this fashion until we think that we can never make money out of investing or we become bankrupt.
For mere mortals, like ourselves, and because our daily lives focus on equally as important but more mundane issues, it is fair to suggest that we need both the discipline and the tools to help us overcome the greatest risk factor of all, the fact that we are human.
Dollar Cost Averaging……the discipline and the tool
As Paul Clitheroe so succinctly suggests, Dollar Cost Averaging, when carried out in a disciplined fashion over an extended period of time, "ensures that you buy fewer shares when the price is high, and more when the price is low." (Source: '10 keys steps to wealth', Penguin 2002)
The discipline suggested by Clitheroe means that if the quality of your investment remains sound, the average cost of your investment will remain relatively low, so that when markets ultimately recover, your profit will be greater. Believe it or not, markets have always ultimately recovered.
Dollar Cost Averaging is "the process whereby a set amount is allocated to specific investments at regular intervals. This is intended to have the effect of lowering the average price paid for the investments." (Source: The Australian Investors' Dictionary)
How can dollar Cost Averaging benefit investment returns and reduce human risk?
Consider the following example of two rational people who each invest the same amount of money into a managed fund over the same time period. Investor A attempts to time the market (investing in January over two successive years), Investor B Dollar Cost Averages.
- Investor A invests $1,000 and decides to invest $1,200 in January of each year
- Investor B invests $1,000 and decides to invest $100 each month
Unit price variations in the following example are kept symmetrical over the period so that the concept of Dollar Cost Averaging remains easy to explain. The outcome could otherwise be manipulated to achieve an unrealistic result if more random unit prices were included over this short time period. Dollar Cost Averaging can be as effective over 12 months as it can be over 5 years; prevailing market conditions will dictate this.
Each individual must in any event consider the proximity of his individual investment horizon, because shorter-term risk (market volatility) may prevent Dollar Cost Averaging delivering the desired outcome within the desired time period, eg exiting the market in May or June is not as beneficial as waiting until the following January as depicted in the table below.
It is hence correct to suggest that it is not "timing the market" that provides the desired investment outcome, but "time in the market".
The table shows that Investor B is $181 or 8.2% better off then Investor A ($2,381 - $2,200 = $181) over the period by using the power of Dollar cost Averaging. Moreover, Investor B has only needed to make a single disciplined decision regardless of markets going up or down. His decision is that he Dollar cost Averages over the full period in question (ie January to January).
Conversely, Investor A has had to be clever enough to "market time" his second investment in January of the second year. This is a random decision, driven possibly by nothing more than Greed.
Investor A's market timing decision is one so frequently taken by us all. Market value is back to $10.00, which was where it was when he made his initial investment (perhaps a sign of market stability?) and hence it has appeared to him to be a good time to invest more money in the market.
Investor A is "clever" because he has missed the downturn during the year and didn't invest again until he again saw "stability" in the markets. He did of course miss the upside after the lowest unit price was reached for this given period but it was probably too "risky" to invest back then. Markets could have dropped even further……
If Fear and Greed didn't influence Investor A and he was, in fact, a brilliant market timer, a better result for Investor A would have been to invest his $1,200 in either May, June, July, August or September. Had Investor A invested his $1,200 in any of these months, his final investment result would have been better than that of Investor B.
To achieve this outcome, Investor A needed to be both a brilliant market timer and to overcome the undoubtedly prevailing emotion of Fear associated when the markets were probably still falling.
Could you have picked the optimum time and then actually invested?
Be honest with yourself.
The Probability of Success
Statistically, Investor A had a 5 in 12 chance of making the right decision (to get a result better than that of Investor B) in terms of which month he invested in. Taking the detail further ….
- The best outcome for Investor A was being $199 better off than Investor B, with a probability of success of 1 in 12
- The second best outcome for Investor A was being $119 better off than Investor B, with a probability of success of 1 in 6.
- The next best result for Investor A was being $39 better off than Investor B, again with a probability of success of 1 in 6.
The issues of Fear and Greed aside, the chances of Investor A doing better than Investor B are less as the comparative returns increase. Investor A also needs to be either lucky in his choice or spend a lot more time analysing the market than does Investor B.
What has been your experience and what has been your mindset when markets fluctuate.....?
How does Dollar Cost Averaging fit into an investment portfolio?
Investing a fixed amount each month helps reduce the volatility of a portfolio and maximises long term growth by systematically buying the same dollar amount of a managed investment each month.
Potential investment returns are at their greatest when equity markets decline and investor confidence is at its most negative. The importance of this concept should not be discounted.
High profile researcher, Stephen van Eyk, agrees with this principle and stated recently that…..
"in the 13 years to July 2002, missing the 10 best days in the market cost 127% in performance over the period. You simply can't say "Ill buy back in later after the market recovers," particularly in an environment likely to feature lower, that than higher, stock market returns over the decade."
How can Dollar Cost Averaging work in the current market environment?
It is true that Dollar Cost Averaging does not guarantee a profit in a predetermined timeframe. It assumes that share prices will appreciate over time.
These points notwithstanding, the graph below shows the performance of Global Equity Markets over the past 20 years, clearly illustrating how dollar cost averaging can achieve powerful returns.
Not unlike the example discussed earlier, investors who made the single disciplined decision to invest $1,000 at 'A' and then $100 per month would have seen their investment grow to $32,160 by the time they reached 'E', even after the "Tech Wreck" caused the market to fall by 48%.
Investors who invested $1,000 at 'D' and were then unable to overcome their Fear, selling at 'E' would have lost 48% of their money. Selling in this fashion excludes any hope of ever retrieving or increasing the original investment, unless the residual capital can be invested at a greater return than international equities might deliver between the point of sale and market growth taking the investment (initial amount and Dollar cost additions) back to its original value and beyond. However, if you bought in at 'D', and Dollar Cost Averaged ($100 per month) throughout the market decline between 'D' and 'E', your loss would have been reduced from 45% to 33%.
Now let's consider 'E' as the half way point in the potentially 'new' cycle (consistent with the $7.60 unit price exhibited at July in the table).
People who invested at Point 'D'
If investors who originally invested at point 'D' continue to dollar cost average from this point, they could achieve the following:
- If the markets increase by an average of 5% per annum over the next 3 years, the total return to investors would be –8% rather than –38% for the period.
- If the markets increase by an average of 10% per annum over the next 3 years, the total return to investors would be 2%, rather than –28% for the period.
- If the markets increase by an average of 15% per annum over the next 3 years, the total return to investors would be 12%, rather than –18% for the period.
People who invested at Point 'E'
For an investor who invests $1,000 for the first time at point 'E' and Dollar Cost Averages $100 per month, they could achieve the following:
- If the markets increase by an average of 5% per annum over the next 3 years, the total return to investors would be 40%, rather than 16% for the period.
- If the markets increase by an average of 10% per annum over the next 3 years, the total return to investors would be 54%, rather than 35% for the period.
- If the markets increase by an average of 15% per annum over the next 3 years, the total return to investors would be 70%, rather than 57% for the period.
Whether you buy at "the top" or "the bottom", a disciplined approach to investing in shares, including Dollar Cost Averaging along the way, generates significant benefits for the medium to longer term investor.
In a falling share market environment, the greatest risk is not necessarily investing; the risk is more likely to be not investing.
Has there ever been a better time to harness the power of dollar cost Averaging than right now? Possibly…..however,
The expectation of a globally co-ordinated economic response should signal a move to an underlying improvement in world economic fundamentals.
In a recent paper, Stephen van Eyk suggested that,
'In Australia dollar terms, international equity markets are now around 40% below the peak levels of March 2000. This setback to prices plus the expectation of a profits recovery has returned the sector to attractive valuation levels….within international equities, we recommend a strong overweight to growth stocks, which have recorded huge price drops (60%-70%) as economic conditions deteriorated in the past few years.'
Disciplined Investing (through Dollar cost Averaging) in Managed Funds that focus specifically on superior quality companies that have strong management, visible earnings growth, high margins and excellent pricing power at a time when valuations appear more reasonable than they have in three years, increases the probability of higher returns over time.
History reveals many examples of share markets experiencing sharp declines (creating opportunities for the disciplined investor) only to recover and go on to greater heights – perhaps now is one of those opportunities? Speak to us at Advantage One………….We’re your Advantage!
"Take care of the pence, for the pounds will take care of themselves…." (Lord Chesterfield, 1747)
Source: Adam's 'Investor Insights' – Allianz Dresdner