The 3% rule for wealth preservation

If you want to maintain your wealth in real terms, you can probably spend no more than 3% of your capital each year.

The idea is that real interest rates are generally around the 3% level. At the moment for instance, five year rates are roughly 5%, inflation is roughly 2%, and that leaves you 3%.

Now you may think that you can earn more than the 5% offered by interest rates. Investing in the share market for example, has outperformed interwst rates over the long term, so that could help. But by trying to do better than interest rates you will also risk losses. The share market can be volatile with long bleak periods for investors who move away from low risk investing. The other problem of course is tax.

The fellow who won the lottery could probably have counted on earning $30,000 per year in real terms if he had invested the entire $1 million. That is probably less than his job was paying. So even though he feels rich, and all his friends want a loan, he may struggle to live off his capital. He would need to be frugal; perhaps the cars and the studio weren't such a good idea.

The task of just maintaining wealth is a challenge for many people, not just those lucky in the lottery. The era of low risk, high returns of over 10% is over for the moment. Those days are gone and wealth preservation is more difficult.

With success, bank some profits

If the fundamentals continue to look good and are supported by a favourable price trend, do not take profits.

However, if you are doing particularly well, you should cut winning positions to keep a balance in your portfolio and take cash out of the market.

There have been some very high-profile billionaires who have gone completely bust. They probably took a lot of risks to get there, which were too bold for most people. Why didn't they just put a lazy hundred million on the side, in case it all went horribly wrong?

Here is a sensible way to lock-in some wins.

Value all of your positions on the basis of the current market price. This process ignores your original entry price, and any other price along the way, such as a high or a low.

If your investments are going really well, you may find that their mark-to-market value significantly exceeds the original risk amount you had in mind.

As an example, say you, allocated 20% of your assets to trading, and the positions have done so well that on a mark-to-market basis, they are now worth 40% of your total assets. Here you should probably reduce your positions and bank some profits. This would even be regardless of supportive fundamentals and a trend in your favour.

Over the years there were times when an investor or trader reduced positions which were doing well and which looked good going forward. Those decisions had nothing to do with their views on their fundamentals, but were simply to take cash out of the market.

Exiting a winning position for traders

A reliable way to exit a winning position with good fundamentals is to allow the price trend to finish. This demonstrates that the idea has run its course. The price reaching an arbitrary target or a period of time elapsing is not a reliable signal. Even if a trade is doing well, keep an eye on those fundamentals.

You will never have the satisfaction of getting the best price or the biggest possible profit. If the fundamentals remain the same, wait for the trend to turn, before getting out of a winning position.

Buy and Hold - may have had their day

Buy and Hold mantra

One popular theory is that investors should buy and hold their stock investments. They should not try to outguess the stock market. This idea became a mantra after the market recovered so well following the 1987 share market crash. The crash now only looks like a hiccough from the great bull market of the 1980s and 1990s. That recovery was a manifestation of the market's long term resilience.

A related theory is that the stock market should always outperform bond yields over the long run, as stock investors are compensated for the extra volatility.

These types of theories may have faded a little now, after global investors experienced the bear market in 2000 and the recent 2007-2009 severe bear market. In the US, the broad stock market indices closed lower in 2005 than five years earlier. Five years is a long time, even for patient investors.

As the buy and hold theories have become widely held, the effect has been to push prices higher, increasing the entry cost for new buyers and removing their attraction - a kind of self-defeating prophecy.



Using PE ratios

Other theories, based on ratios, such as PE ratios, would have been very effective in signalling the tech crash a few years ago. However, using this would have made many investors over cautious, and missed much of the fantastic bull market in the five years earlier. That would have cost investors a large amount of missed profits. (Caution!! Maybe risky strategy.)



In summary

Choose the best periods to be invested in the stock market. There are long periods of over and underperformance.

Watch the economy and the big picture influences.

The best way to time investments is to allow some broad consensus to build in the market and invest after the price begins to move. (For example: There is a consensus building that the worse of the recession is over and the world economy is heading towards recovery. Moreover, the prices have moved.)

Crisis situations almost always provide an opportunity

Don't buy into falling markets. The occasional successes will not pay for the more numerous failures. The falling markets can surprise many of us by how far they move. Recall the recent 2007 -2009 severe bear market and those who bought big and get caught in the falling market. Among them, Temasek, Oei Hong Leong, the German industrialist who committed suicide for betting on a auto stock, and others.

Panics can lead to an imbalance in supply and demand

Nevertheless, there is an exception: crisis situations. In crisis situations almost anything can happen because there is panic in the markets. You see the most controlled and sensible people completely lose all their judgement when they are under intense pressure. Sometimes the whole market is awash with nail-biting investors and traders, feeling nervous and confused. With the volatility we have experienced the last 25 years, there have been many such episodes. The share market crash of 1987, the emerging market crisis of the late 1990s, the tech wreck, and 9/11 are just a few that come to mind. And, undoubtedly, there will be many more.

The reason that there are opportunities on these occasions is simple: a falling price triggers more panic selling than it does bargain-based buying.

During these crises, many players will be forced to cut their positions regardless of the price. Some funds will have lost so much money on many different investments, that their very survival would be threatened if they lost more. They may reason that by selling, they take a dreadful loss, but at least it does not put them out of business. Even though holding on may be a great trade, they simply cannot take the risk. There have been many instances of a senior manager ordering a fund manager to cut, and ignoring their heartfelt plea not to do so.

At this point fresh buyers could come into the market looking for value. However, at times like these, potential buyers may be too distracted with their own problems to do anything. This particularly affects smaller markets since fewer people are watching them anyway.

Suffering from this lack of buying, the market could paradoxically be struck by new selling. Some hedge funds and other momentum players may ignore fundamental valuations and see selling as an opportunity, as they look for the price to go even lower.

While all of this is going on, you may be able to step in. Hopefully, you will have followed good risk management so that you yourself are not facing a crisis, and you can keep a cool head even as others panic. You should be extremely choosy over how you get involved in the market - try to consider many different opportunities and don't necessarily jump at the first one you see. In a genuine crisis, there will be no shortage of ideas.


Ref: 100 Secret Strategies for Successful Investing by Richard Farleigh

Pros and cons of using stop-losses

Here are two episodes to illustrate the pros and cons of using stop-losses:

Cons

"So, in December 2003, I invested in the company at an effective price of 90 cents, which implied a market capitalisation of about $220 million. Over the next six months the price had a strong trend - downwards. In July 2004, it fell to as low as 55 cents.

This was around the stop-loss level I had in mind when I invested.

There didn't seem to be any reason for the dramatic fall. Everything seemed to be going on track for the company. The network was being set up, trials of the system were progressing and the modems they had ordered were being delivered.

Here was a classic stop-loss dilemma. If I had thought that there was any way the price would drop so severely, I would not have invested. The fundamentals were sound, so if anything the company was a buy at this price, rather than a sell.

I held on to my investment. Since I had quite a large position, I didn't buy any more. Fortunately for me, the price recovered as the company achieved some success with its product launch in August 2004 following a strong advertising push. That sent the price to over $1.10. I later exited my position at around $1.00, when I became worried about potential competition emerging from other companies."

Pros

"I had a tough experience with my ARC shares, where cutting a deteriorating position would have been the better choice than hanging on, and where clearly I was stressed and lacked discipline - exactly the problems that a predetermined stop-loss strategy seeks to avoid. "


---

In the first episode, the investor did not use a stop-loss, and the market recovered allowing him to salvage a small percentage profit. His confidence was rewarded.




Summary on stop-loses

Have a stop-loss in your mind when you invest and if the price hits the stop-loss level, always cut if:

• the loss is threatening to be destructive;
• you are confused about what is going on; or
• the fundamentals are moving against you.

You should only keep the position and consider increasing it if you remain genuinely confident about the underlying fundamentals. Experience will help you recognise when you are starting to rely on nothing but hope. If you do stay in, choose another stop-loss level as a reference point, and stay disciplined.

You should also manage risk by not betting too much on one idea and by anticipating market moves twice as big as seem reasonable.

The stop-loss dilemma

This technique enables an assessment of the potential cost if things go wrong. If the investors buy a stock at $100 with a stop-loss price of $75, they know in advance that their maximum loss is $25. There are also other variants which aim to limit the potential reversals of profitable positions. With a trailing stop-loss, the stop-loss price rises in line with the market price. So if the market rallies by $10 to $110, the stop-loss price might also rise by $10 to $85.

The benefits of a stop-loss

It forces an investor to be disciplined. When a position goes wrong, it can cause stress and cloud people's judgement. Anticipating this, and deciding on a stop-loss level in a calm and relaxed manner beforehand, can ensure that an investor will remain objective.

A stop-loss also allows a specific amount of capital to be allocated to each idea. So an investor might be prepared to lose say, $10,000 on a hunch, and say, $25,000 on a firm conviction.

The argument against stop-loss

It doesn't seem very scientific.

Is this necessary if the other risk management ideas are followed?

The choice to cut a losing position is a dilemma.

On the one hand, the positives for managing risk and preserving capital are clear.

On the other hand, if you are confident an investment is a good idea but the price moves against you, perhaps you should be buying more, or at least holding, rather than cutting.

How you may overcome this dilemma?

One discipline which you should use is to value your position regularly using the current market price. A losing position clearly means that something unexpected has happened.

When you invest, have a stop-loss in your mind. If your investment hits the stop-loss level, make a judgement on whether to cut, based on your confidence at the time about the position.

If the loss is threatening to be destructive to your finances, it is absolutely vital to cut. To be at this point, the price must have moved a really long way against you, if you have not bet too much on the idea in the first place.

You must also cut if you are confused about what is going on, or if the fundamentals are moving against you. In these situations, you see the prices go further than expected.

The decision not to cut

There are times not to cut a position, even if it reaches your stop-loss level. These are when two conditions are satisfied:

1. you have the capital in case of further losses;
2. you understand the reasons for the adverse price move, but remain confident that there will be a recovery.

Here it may make sense to hold the position and even to consider buying more. (It is sensible to see the market starting to recover before adding to a position.)

The decision to keep a losing position must not be based on emotion or on any sense of living in hope. You must admit to yourself that things have not gone the way you expected, and that since you have been wrong up to this point, you may well be wrong again. There is an old saying along the lines of 'the market can remain irrational much longer than you can remain solvent'.

Summary

Stopping out is the hardest transaction. No one likes to give up hope. But it is essential in some circumstances. Beginner investors should be especially cautious about mounting losses.

Sometimes you cut a position and then the market recovers. Don't be put off stop-losses by those experiences. The horrible feeling of cutting a position only to watch the price turn and recover is one of the worst for an investor. You are talking about probability and random events, and over time all sorts of good and bad things will happen. You have to look at the long term. Normally after cutting a bad position there is a strangely cleansing feeling - some people say it's a bit like getting out of a bad relationship!

Stop-loss maybe unnecessary for some or many investors if the other risk management ideas are followed.

Qualitites of the successful investor

Drive and ambition are absolutely essential. You won't make it in the financial world if you're lazy.

The risk-taking elements of investing require self belief and genuine confidence. This is particularly important to handle losses. On the other hand, a big ego is a negative because markets cannot be fooled by bravado.

Intelligence and practicality are essential. Intelligence is the ability to sort through a lot of information and to see what is important. There are many educated and knowledgeable people who are not especially intelligent. The ability to use the information is what they lack. An ability to simplify a complicated subject has its rewards.

Above all, you need to enjoy what you do. Financial markets are the most exciting experience imaginable.

A level of optimism like this is important. There is a book by Dr. Martin Seligman, Learned Optimism, which relates the level of a person's optimism to their success. It argues that the most successful people are rational optimists. Optimism relates to an attitude towards risk. Pessimism stops people taking any risk.

Assess risk - and then double it

Risk assessment is not always an exact science.

Occasionally, you hear of investors who have been hit by losses so big that they find themselves "out of the game". The reason is the same in every case: they have not managed their risk.

The most important is to always have a rough idea of how much money you could lose if the markets move against you, and you should be able to withstand that loss if necessary.

Risk assessment is not always an exact science. Judging how much a position can move against you will be nothing more than a gut feeling. It is difficult to be more scientific about it because:

• using history as a guide is not always effective, as the world is always changing.
• even in normal conditions, there is a lot of 'volatility of volatility', as the market goes throught quiet and crazy periods.
• the size of the theoretical maximum loss is all of the investment, because a price can go to zero. But this is hardly expected to happen.
• sophisticated statistical analysis has often proved inadequate, which is why LTCM had come unstuck.

Here is how one investor estimate his maximum loss for each position based on what he feel could happen in a normal environment. A normal environment is one which applies four years out of every five. (For every 5 years of investing, you can expect to meet 1 bear year.)

Step 1: He assumes for risk purposes:

• Blue chip stocks will not fall by more than 25% in the four years out of five. So for every $100 invested in the big names, he could expect to lose $25.
• Smaller stocks are normally more risky. These will not fall by more than 50% in the four years out of five. Therefore, for every $100 invested in a small stock, he was risking $50.

With this estimate for each position, he can simply add them all to get an idea of his total risk ($R). This gives an estimate of how much he could lose in reasonable circumstances - four years out of five.

Step 2: For the one bad year in five, it could be worse than that. The loss will be worse. For this reason, he assumes that he could possibly lose double that amount ($2R).

Step 3: Making some deduction to my total risk. It would be fair to expect that not all of his rainy days will happen together. This is the benefit from diversification. Therefore, he can make some deduction to his total risk if he feel not everything can go wrong at once. (But be careful, some big name hedge funds have come unstuck by underestimating how their positions are correlated.)

To summarise:

This simple and logical technique of risk assessment involves:

• for each position, assess how bad a loss could be in a normal environment;
• double the amounts; and
• add up the potential losses, and take some off the total if it is justified by diversification.

The idea is to be comfortable with the total risk level. It is vital that you could withstand that loss, because a disaster may happen. So simply choose the size of positions so that potential losses are manageable. No market is too risky if the position is not too big.

With the right approach, you should be able to "stay in the game". Do not take too much risk.

Was the potential reward worth the risk?

An investor may be tempted to chase that little bit of extra return on his investment. Perhaps, he may put his life savings into saving schemes that pay slightly more than ordinary bank deposits. However these types of deposits are a little bit more risky. Every now and then they can blow up. It's always sad when these, usually, small investors have lost their savings that way.

Is the higher return worth the risk?


There are many types of investment which pay above market returns. The problem is that every now and then there can be a big crash which can take away the profits and cause losses. These types of investments can give the illusion of being very comfortable when they are doing well. However, there is an asymmetry, because most years they will pay-off, but in a bad year they can be horrendous.

If an investment opportunity looks too easy, it's time to smell a rat.

Everyone is a hero in a bull market

Psychologists have identified that it is human nature to attribute our wins to our skill and our losses to our bad luck. Don't fall for this trap.

With trading and investment, luck often parades as skill, especially when a market is doing well. During a bullish run in the stock market you will often meet someone who is very happy with their ability to pick the right stocks, because they have backed one that has performed well.

But in the same way that a rising tide lifts all boats, even the rusty ones, many stocks do well in a bull market, even if they're nothing special. So the profit may have more to do with favourable big picture events at the time, such as a strong economy or falling interest rates, than with anything company specific. This really means that the person was lucky rather than skilful.

Be mindful of the old chestnut that 'everyone is a hero in a bull market'. As prices went higher and higher, they increased their investment sizes, so that when the crash came they had far more money at risk than they would have imagined just a year earlier. It ended badly. Profits tempted them in, and losses forced them out.

Listen and read very critically

Keep a critical mind when you read or hear market comments. Ask yourself:

• Does the commentator have any track record?
• Are they considering all of the factors?
• If they are pointing to influences which have been present for some time, why should they start moving the market now?
• Are they relying on hindsight?
• Are they hedging their bets?

Be a sceptic. Who is the writer? Don't listen to ill-informed, ad hoc, one-eyed, overpaid, inexperienced, sensationalist, untested, uncommitted and uninvolved people!

It is just too difficult sometimes to have a view. A commentator can gain a lot of respect if he actually said, "I don't know.' He could then continue 'because of the following...' and you know you're going to get a balanced answer. It's brave to say ' I don't know'.

Respect the market, not the experts

The power of the financial markets should be daunting, but many people are not deterred.


Why do people underestimate the difficulty of making money in the financial markets? Here are some main reasons:


1. The experts in the media

2. The widely held belief that many professionals are regularly able to beat the market

3. Some people like to trade the market because they are gamblers - usually with disastrous results.


Experts

The experts in the media promote the idea that markets are easier than they really are. A guy on TV or the newspaper says that the price is going to do this and do that, and it sounds easy. The market can be beaten.

If the media put out a continual broadcast that the market has processed all the information and that the price is right, people would get the message. But they rarely say that.

The experts and media message is that the behaviour of the market can be forecasted. It's a persistent and seductive message, and people think 'ah, I can have a go at that, I can make money out of that'.

You can't blame the average person for following what they read in the newspaper and what they're being told on TV. However, many so-called experts are just commentators or analysts who often don't have any track record and who often, to my ear, don't even make much sense.

Listen critically, rather than just accept what you're hearing or reading. You may be surprised to find that they're not really experts.

The fact that the media and their financial guesswork is entertaining and interesting doesn't necessarily mean that it's the truth.


Most professionals are not outguessing the market

Ever wonder about all the money made by the people working on Wall Street or in the City of London. Surely they know something about markets?

The truth is that very few are successfully backing their views on markets. Most of them wouldn't have a clue what the market was going to do. They make money in other ways, such as commission and mangement fees.

It's not that people working in finance don't know anything - they are usually very good, very smart people. The fact is they're making money out of sales, client relationships and by doing transactions, i.e. facilitating the whole process. They're not actually making money out of successfully predicting what's going to go up and down. They're, therefore, not a reason for you to take up punting cotton futures in your spare time.

Equally, don't be too impressed with your stockbroker just because they sound confident and know a lot of stories and figures. More information does not necessary make the market more predictable. The extra information is probably useless as the price has already adjusted for it - it has been 'priced in'. It's about as useful as playing roulette and knowing whether the roulette wheel was made in Taiwan or Korea.

The critical test is: does the broker make a living out of picking stocks? Probably not. He or she is sitting in their seat because they're getting the fees you pay them to buy and sell on your behalf. It's very easy for someone to have a view when it's with someone else's money.

Speculation is usually only successful when it is in line with the fundamentals

Speculators are often unfairly criticised. The market needs them. Speculators add important liquidity.

Those who invest in small stocks will know. Often these stocks would not have much daily turnovers if it were not for speculators. The longer term holders of these stocks do not buy or sell very often. For those wishing to find buyers or sellers of these stocks, it is a great benefit to have speculators as they are more active.

Speculators also play an important role in taking over risk that others don't want. Wheat farmers, may sell their crop well before harvest at a fixed price for a future delivery date. That way, they can remove the risk that there is a bumper season and an oversupply that forces prices lower.

Speculators are often criticised for pushing prices to unrealistic levels. This argument is flawed. In fact, speculators are usually punished when they do this, because if they are wrong about the real values, they are usually the big losers. The tech boom and bust, where perhaps it was speculators who drove prices to very high levesl, is a great example. Most of them paid very heavily when market prices crashed to a fraction of the higher levels. Though what a great opportunity it was for the more savvy investors to sell near the highs.

So, speculation is usually only successful when it is in line with the fundamentals, and when it is pushing prices to a level that more closely reflects fair value.

Aiming for higher returns without losing your pants!

During the 2007-2209 severe bear market, there were many investors who cashed out of the market, at various stages of the unfolding bear. Many were happy that their capitals were not at risk during the turbulent bear evolving early stages. They were waiting to re-enter the market when it is 'safe' again. Just as they might not have cashed out at the 'right time', likewise, they might not have re-entered the market at the 'right time'.

What defines safety for these investors? They are probably referring to not losing their existing capital. Of course, the safest place was the money market or the fixed deposits. At which point in the bear market will they re-invest into stocks? During the slippery downturn, during the ups and downs, or when the market has turned up convincingly. I suspect many such investors having 'rescued themselves' or 'cashed out' of their stocks will not put their cash back to work until the market has turned up convincingly. This means they would have lost out on the fantastic return of the market during the last 2 months.

Therein is the difference between Warren Buffett and fellow value investors, and the general crowd. They bought at the time when everyone was fearful, probably committing more money into stocks too. The few value investors who spoke on Bloomberg or CNBC during the severe downturn sharing their views that they were net buyers appeared silly in the public eyes when the stocks prices sank further. But events have since proven these value investors to be more right than wrong.

Having a good knowledge of the risk/reward ratio offered by the market is helpful. The safest time to invest is when the market is at its low. This is also the time when the downside risk is small, though not completely eliminated, but the potential for upside gain is high.

Warren Buffett was right again. He asked to 'Buy America' in October 2008 when the US and world market 'fell off the cliff' following the Lehman collapse. For those who have bought following his call, subsequent events should have ensured good returns.

How can we aim for higher returns? Here is another lesson from Warren Buffett on this. What Ben Graham did was to inspire Warren Buffett with his investment strategy of buying bargain stocks that were selling below book value regardless of the nature of the company's long-term economics. This was something Warren Buffett was able to do with great success during the 1950s and early 1960s. But he stayed with this approach long after it wasn't viable anymore - the chains of habit were too light to be felt. When he finally woke up in the late 1970s to the fact that the Graham bargain ride was over, he shifted over to the strategy of buying exceptional businesses at reasonable prices and then holding them for long periods - thereby letting the business grow in value. With the old strategy he made millions, but with the new one he made billions.

As Buffett modified his strategy aiming for higher returns in the late 1970s, we should also regularly re-appraise our philosophy and strategy, through acquisition of appropriate investing knowledge, skills, and its better execution. There is definitely a 'holy grail' in value investing; to benefit from this hugely requires a deeper understanding of its core principles and better execution by the practitioners using proven safe strategies. So far, none is better than Warren Buffett, the accomplished sage. So much has been written on his strategy and method, and we only need to emulate these.

Aiming for safety of capital with a reasonable return was the initial goal. With increasing knowledge and skill, perhaps, aiming for safety of capital and higher returns are achievable. The returns of many investors are compromised by certain knowledge they possess and certain knowledge they do not have. Of course, you may not know what you don't know. Investing is a life-long passion for some. Having a good investment philosphy and strategy is the key. There is constant learning and re-learning. Some knowledge needs to be unlearned. As Warren Buffett said, "The chains of habit are too light to be felt until they are too heavy to be broken."

Also read:
You've Sold Your Stocks. Now What?

Dollar Cost Averaging vs Simple Averaging

There is a difference between simple averaging and dollar cost averaging.

Tan Teng Boo averaged down on a stock and profited. Let us look at what he did.

This was taken from this week's icap newsletter:
"A stock that the i Capital Global Fund invested in plunged around 85% during the 2007-2009 bear market. However, instead of selling as it dropped, we bought so much more of this stock that the cost price plunged around 80% too. By now, the i Capital Global Fund is sitting on a gain of 175% on this particular stock. The reason why ICGF bought so much more was because if it was attractive at higher prices, it is even more attractive at depressed prices since the business fundamentals of the company have not changed. "

What ICGF did. http://spreadsheets.google.com/pub?key=r_MxUHLmwJhsKRpR7JklS1Q&output=html

Simple Averaging

The first point to clear up is actually the difference between dollar cost averaging and simple averaging. What Teng Boo did above was not DCA but simple averaging.

Buffett does not believe in DCA. "It does not make sense investing in stocks when the prices are high." However, Buffett will employ simple averaging, often buying a good stock he likes in large amount when its price is down for no good reasons.

DCA

Those employing DCA should learn its limitations too. It is a way to diversify risk, and is definitely not a strategy to optimise your returns. Various studies quoted that returns from lump sum investing beats those from DCA, 60% of the time.

There are risks too from DCA. If the stock price tanked due to deterioration in its fundamentals, using DCA equates to throwing good money after a lousy company and should not be employed. Also, remember that the same amount used for DCA into a stock is an opportunity cost, to investing in another stock.


The Only Reason to Simple Average or Dollar Cost Average

I did pick up a very important point. It was good to see this advice in print. For those who are investing in good high quality stocks, averaging down can be employed in ONE particular situation, when its price tanked for no good reasons. However, there is still the need to ensure that your good high quality stock's fundamentals have not deteriorated.



To summarise:

There is only one reason that justifies simple averaging or dollar cost averaging - when its price tanked for no good reasons. However, there is still the need to ensure that your good high quality stock's fundamentals have not deteriorated.

If you thought that a stock was undervalued at $34 and without the fundamentals of the company changing, the stock got unfairly beaten down.

An investor put it: "The company and its business have not changed. The only change is its share price got beaten down."

Risks of Dollar Cost Averaging

Risks of Dollar Cost Averaging
by Jim Wang Print Article Email Article Share on Facebook

This is more like a mini-Devil’s Advocate post because of the nature of the idea of dollar cost averaging. Dollar cost averaging isn’t a strategy that is meant to guarantee with any sort of high probability that you’ll generate profits from the stock market, it’s meant as a risk mitigation strategy to help weather the volatility of the stock market. That being said, some people believe that by using dollar cost averaging you can get better returns, which is incorrect and that’s the idea I’ll be tackling today.

The idea behind dollar cost averaging is that you buy smaller lots of a stock until you build up the amount that you truly want, getting a nice average purchase price that isn’t at either the peak or the valley of your period. The stock market is volatile on a daily basis but increasing in the long run so by spreading out your buys you are smoothing out the curve. Proponents advise this because you won’t run the risk of buying your whole lot at a peak thus lowering your total risk involved. This is by no means a guarantee that you’ll generate profits, just that you didn’t pay the maximum price for the share in the period you were acquiring. Now the problem comes when people believe that this means DCA is a strategy for higher returns… it’s not and here’s why.

No Peaks But No Valleys Either
Just as how you didn’t buy your shares at the peak in its price, you also didn’t buy it at its lows either. If you bought one round lot (100 shares) at 10AM, one at 1PM, and one at 3PM, you probably paid three different prices for those three hundred shares and that, of course, guarantees that your average price paid is neither the peak or the valley of the stock during that period of time. If the stock was moving upwards, you paid the least in the morning and the most in the afternoon - which was more than if you bought all three hundred shares at 10AM in the first place. Now, if the stock was falling, you saved yourself the heartache as well but there is no guarantee either way.

Multiples Buys Means Multiple Commissions
Hmmm… who is recommending that you use dollar cost averaging? Could it be the folks who stand to benefit from more trades? If you make three buy orders, you generate three times the fees and commissions than if you made only one buy order! No wonder they recommend dollar cost averaging, it means more money in their pockets.

Lots of Effort
I don’t know of many brokerages, short of something like Sharebuilder where you’re paying a premium otherwise, where you can schedule purchases by time rather than by price (limit orders) and so in order to do dollar cost averaging, you’re going to have to execute those trades pretty much manually, which quit a bit of effort (at least more than making one buy).

So remember, dollar cost averaging isn’t a trading methodology that can guarantee that you earn money, it’s only a way of smoothing out your risk. Once you remember that, dollar cost averaging isn’t all that bad if you’re willing to do the legwork.

The Pitfalls of Dollar Cost Averaging

For example:

I bought 100 shares of Microsoft at $34.00 a year ago, making my investment in Microsoft $3,400 (100 shares @ 34 = $3,400).

Now, suppose today that the price of Microsoft is just $17.00 and I have $3,400 more to invest. I buy 200 additional shares, increasing my total holdings to 300 shares (200 shares @ 17 = $3,400).

Since my total investment is $6,800, my average purchase price is now only $22.67 (6800 / 300).

The Psychology of Dollar Cost Averaging

In our example, we would look at our Microsoft holdings (before dollar cost averaging), and say - this stocks needs to double its price before I can make any profit on it. However, after dollar cost averaging, the stock needs to go up just 5.67 per share before I start to make money. This is a very heartening feeling, and one I’ve done several times. However, if you are averaging just for this warm feeling, then you need to take a hard look at the opportunity costs.

Opportunity Costs of Dollar Cost Averaging

Opportunity cost is what you forgo in order to get something else (economists call it the value of the next best alternative).

For instance, if what I really wanted to do with my second $3,400 was buy Apple stock (trading at $80) instead of Microsoft, the opportunity cost of my decision is the Apple stock. Since $3,400 translates to about 42 Apple shares, the opportunity cost of 200 Microsoft shares is 42 Apple shares.

As long as both Apple and Microsoft grow at the same rate, it doesn’t make any difference to me. It is only when Apple appreciates quicker than Microsoft do I get affected. This is key because stocks that fall tremendously may not rise as much as the rest of the market. The very fact that they fell so much shows that something is wrong with them.

The Only Reason to Dollar Cost Average

There is only one reason that justifies dollar cost averaging.

If you thought that a stock was undervalued at $34 and without the fundamentals of the company changing, the stock got unfairly beaten down.


Should you Dollar Cost Average?

Next time you are tempted to buy more stock to bring the average cost down, ask yourself one thing. Am I doing this for a warm feeling or is the stock a steal at this price?

If you answer this question honestly, you will get it right much more often.



http://investing-school.com/myth/the-pitfalls-of-dollar-cost-averaging/

Dollar cost averaging: Bull versus Bear Markets

Dollar cost averaging: Bull versus Bear Markets

This examines the multiple benefits of dollar cost averaging as a long-term investment strategy.

There are two types of markets: "bull" markets and "bear" markets. Bull markets relate to those periods when the market is trending upwards.

Conversely, bear markets are flat or downward trending. In bear markets, the tendency for most investors is to stay on the sidelines and wait for signs of a market recovery before investing. This makes sense. After all, why invest in a market which is either falling or going nowhere?

The problem, however, is that it is very difficult - many say impossible - to determine when the next bull market is about to start. In fact, it is usually only after many months of excellent returns that a bear market is declared over and a bull market officially in play. As a result, most investors sit on the sidelines for too long and therefore miss out on the substantial gains made at the very start of a bull market.

So, if it is impossible to perfectly time your investment entry point, is it better to invest near the start of the bear market - or wait until after the next bull market begins?

The answer is neither.

Adopting a "dollar cost averaging" strategy during a bear market may be one way to avoid issues of market timing. This is where you invest the same amount of money on a regular basis over a number of years.

There are two performance benefits from this approach.

• Firstly, you are not putting all your money at risk should there be a large market fall early in a bear market.
• And secondly, you are assured that a portion of your money will participate in the early gains of the next bull market.

Here's how dollar cost averaging works.

http://www.zurich.com.au/zportal/cs/ContentServer?pagename=GroupSite/Page/ThreeColumn&cid=1233198359931&p=1159692288459

Lump-sum investing beats dollar cost averaging over 60% of the time

Dollar Cost Averaging versus Lump Sum Investing?

This question actually came up last year, but I didn’t research it very much. My own thoughts were that because the markets trend upwards overall, if you are investing for a long-term period you should get your money in as soon as possible. Sure, you might run into a huge drop, but you could just as easily (in fact more easily) miss a huge rise. But this is too hand-wavy, as scientists would say. I want numbers. So I found some.

Now, wouldn’t it be nice to have a comparison of DCA vs. lump-sum investing for the past 50+ years? We could compare investing $10,000 all at once in January of 19xx, versus using DCA equally over all 12 months of that year. Wouldn’t it be even nicer if we could take into account that any money not used be put in a high-yield interest bearing account?

Well MoneyChimp did just that all the way back to 1950. The result? I used 4.25% rate for bank interest, and over 60% of the time, lump-sum investing beat dollar cost averaging. This result of DCA losing out about 2/3rds of the time is supported by historical back-testing from 1926 in this article from the Financial Planning Association: ‘Lump Sum Beats Dollar-Cost Averaging‘. (Just read the conclusion if you get bored.)

Of course, past performance does not guarantee future results. And DCA would smooth things out if your time frame is really short. I think everyone should consider the facts above and make their own decision. But I bet with the odds, and the odds are that I should invest it as a lump-sum.