Investment Moats

Sunday Times teaching some questionable lessons in dollar cost average investing

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This morning Sunday Times published an article on a less painful way to invest.

The feeling I get at the end of this article is that it encourages more market timing rather than having an investment plan.

If you don’t have an investment plan and pre-committing to it, you are kind of investing blindly.

So this article was written by Jessica Cheam which talks about whether to use dollar cost averaging or lump sum investing.

This is a tried-and-tested formula, but a study last year by mathematics majors at mutual fund giant Vanguard put paid to this theory by offering evidence that it is better to put your money in the market all at once.

In the study, entitled "Dollar-cost averaging just means taking risk later", the firm took two sums – $1million and $20 million – and compared the historical performance of investing these amounts in dollar-cost averaging versus lump-sum investing across three markets – the US, Britain and Australia.

Their main finding: The longer one took to invest, the lower the return.

On average, they found that the lump-sum approach outperformed dollar-cost averaging about two-thirds of the time. This finding is consistent with the fact that the returns of stocks and bonds exceeded those of cash over the study period in each of these markets.

I think its been said a few times that lump sum investing works better because

  • overall the market direction is up
  • you seldom get a 10-15 year period where you end up losing money in equities (there are exceptions such as Japan)
  • your money starts working earlier compare to DCA because a portion of the money have less time to earn

But if the investor is concerned with minimising downside risk and potential feelings of regret (from investing a lump sum immediately before a market downturn) then dollar-cost averaging makes more sense.

It warns, however, that this choice should be weighed against the fact that returns of cash are lower than returns of stocks and bonds, and that delaying investment is itself a form of market-timing – something few investors succeed in.

There is a psychological problem that if you have 100k, plunking it down at once will cause you to lose money.

In the case of my friend, who chose to DCA 2 months before the top of the 2007 market crash (read I DCA at the market top), what Jessica said makes much sense.

The top was at 3800 and after 6 years we are neither there. I have not done any simulation of  what happens if he invest with a lump sum back then, but I believe my friend’s result won’t be pretty with dividends factored in.

Delaying your purchase into stocks but sticking to a regular purchase schedule is better than trying to time the market with a large investment.

She seem to be basing her experience on what she had gone through. Now what happens if she purchase her blue chips in 2010 lump sum? or the 2011 correction?

Could she have sung a different tune?

There seem to be a cognitive flaw in the way she reads her “mistake” in that fear is rationalizing that she should not do this again.

I wished I had given more thought to this strategy when I plonked all my spare cash into a couple of blue chips about a month ago when – now with hindsight – the market was oversold.

With no extra cash available, I grimly watched my investments sink deeper and deeper into the red as the market sell-off began when speculation over moves by the US Federal Reserve to taper its stimulus began to take hold.

I did the next best thing: I waited for the market to rebound slightly and then I sold my positions at a significant loss. It pained me, but at least this enabled me to reclaim my capital, and now, I’m waiting for further market corrections before investing again. And this time, I won’t be investing all of it.

You guessed it, I will be investing in smaller chunks instead, at regular periods of time. This way, I stand to gain from the biggest benefit of the dollar-cost averaging strategy – minimising regret.

There is a difference when you actively invest in individual stocks (in her case blue chips) versus a unit trust or a ETF.

You can dollar cost average into a fund that is unlikely to go to zero. Markets have a way of overshooting on the downside.

Take the case of the emerging markets, the India and China doom and gloom.

Because it’s a basket of stocks, the risky individual stocks that blow up will be replace by better quality ones. Funds seldom go to zero, or permanently impaired.

When things have a tendency to go up generally over the long term, dollar cost averaging is better psychologically for most people, unless u have a strong sitting power.

But when it comes to individual issues, fundamentals do change. Good companies may face declining economics that permanently alter their future earnings capability and thus affects their future price.

If you DCA into a lost cause, it is unlikely that they will end up in a good state in the future.

This article seem to say that blue chips will not die. I hope she did not plonk into NOL then.

What is important is proper valuation of the company

  • What is its business case and future cash flow generation capabilities
  • The risks and opportunities of the business
  • With the 2 you will be able to come up with a value for it
  • With the value you can measure against current price

Without knowing the rough intrinsic value, and making use of what technically oversold indicators,  you may still start buying at a high price!

If your valuation skills are not up to scratch breaking it to a few portions and investing based on percentage drawn down make sense.

But the stock could be oversold, and then after consolidating for a week, still head down.

If a proper valuation is carried out,  your purchase would have a high margin of safety, and baring any unknown risk not  buffered into your value,  it should eventually trade higher.

Summary

I am not against market timing, but somehow this article doesn’t seem to be highlighting the differences correctly.

Using a passive investing research article to justify her individual stock investing mistake.

If you know the value of an IPAD, you would know what is cheap or not cheap.

You wouldn’t worry if its oversold or not.

If it gets cheap you will just buy it.

Not all of us can visualize investing in that context.

If there is one lesson I gather from this article, it is really how we sometimes cannot take the psychological impact of seeing our money losing money in the short term and not doing enough homework to have a high conviction in our purchases.

Some past commentary on similar issues:

Oh Shit! I started DCA investing at the top of the bear market!

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Investing using dollar cost averaging at the market top may not be that bad if you invest in the right investment and are discipline enough throughout.

In the past week, we written about the advantages of investing in low cost index funds or exchange traded funds (ETF) for people who do not want to take such a hands on approach with investing but want to make the virtues of early life compounding work for you.

In the Singapore context, many have highlighted Street Tracks STI ETF as the ETF that they use when they want to practice low cost index investing. STI ETF since 2002 inception have generated an annualized return of 9% with 38% of the returns originating from dividends. (Read report here)

Meeting up with an old friend

I managed to meet up with a friend of mine that I haven’t seen for some time. I best remember him for being a person unaffected in the most difficult times we faced.

We used to share some conservations on investing and the experience I remember best was his investment in Macdonald’s Corporation (MCD). MCD is the best dividend growth stock perhaps in the past 10 years. Great business model and it starts at a 3% yield but the crazy thing is that its dividend growth for 5 years have been 20%! That 3% basically doubled in 3.6 years.

My friend probably bought MCD at $70 (which at that time I thought it was expensive. ha! anchoring at work!) yielding 3%. The price now is $94.

Buying STI ETF near the all time high

So he lamented that he started investing in the STI ETF. To him it’s a no brainer way of making your money grow with the progress of Singapore.

The problem is that he invest in May 2007. Now when you hear that, your heart may jump out since that is at the very top of the Great Financial Crisis (GFC) that took nearly 60% off the STI index.

Dollar Cost Averaging the STI ETF using Lim and Tan Unit Share Market

Now I found out further that he didn’t just invest at the top of the market.

What he does is

  1. Set aside a sum of money per month
  2. Every month since May 2007 he put $1000 into buying odd lot shares of STI ETF
  3. Doesn’t like to wait for three months then invests

Now he uses Lim and Tan which gives him access to the unit share market.  For the readers asking me how to dollar cost average with a smaller sum this may be the way.

My take is that Lim and Tan charges you the same commissions like you trade the full lot, compare to Philip Securities which charges  $10.

Price Chart for STI ETF

(Click to see larger graph)

The price where he started investing was absolutely brutal. If I am correct that is the worst market plunge since 1997 Asian Financial Crisis.

Since then, the market didn’t return to the top of 3800.

The price summary shows where he got invested in. The common guess is that my friend suffered large losses even till this date. Even 2011’s high took it back only to 3300.

Total Returns of his Dollar Cost Averaging plan till date

I talked in the past of another friend who stopped his Dollar Cost Averaging plan when he anticipated the bear market. (See report here)

Good choice? That friend still believes in his astute market timing capabilities.

Lets look at this friend’s returns.

(Click to see larger image)

By adding $1000 every month, he put it a total of $50,000 to date. His return for 5 years is 9.24% with 85% of returns made up by dividends. Annualized the return is 1.7%.

His average cost have gone down to $2.80, which was much lower than the $3.10 he estimated.

Disciplined Approach to Investing

What impresses me about how my friend conducted this was that he is not DCA automatically, but every month he has to initiate that himself!

My friend did not let the early losses get into his head to stop him from abandoning his DCA plan.

And because of that it really saved his portfolio because he added a lot of units at $1.60-$1.80 prices which balance things up.

The majority of the returns had been from dividends, and without the dividends the returns would have been even more pathetic.

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Should you invest your bonus in the stock market?

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December to March is usually the period where working people get their yearly bonuses. How do you use your bonus?

Smaller Bonus this Year

This year, most foresee that their year end bonus will shrink.

The two-day poll of 100 people, conducted in both the Central Business District and heartlands, found that the majority of Singaporeans foresee smaller bonuses this year compared to last year.

Almost 75 per cent polled said they believe their bonuses will shrink, which is a prediction seconded by human resource managers.

– SPH

Like wise, I do not expect to receive much special bonus this year. Its likely to remain lower than norm consider the firm is hit with some bad results during the quarters.

Part of the overall compensation

I do see that your annual bonus be part of your overall compensation package. And as such it should be manage as a total annual package instead of treating it as something of a windfall.

The fact is that folks that work in Keppel will get their 7 month bonus while some companies will struggle to gain any. Yet the workers in Keppel may each be paid much much less than the standard monthly pay of bankers who will not get much bonus.

Reward yourself but save up for the rainy day

I used to be in the frame of mind that you should always save as much as possible. But life goals change and for some people they really work hard for it.

Rewarding oneself by going for a good holiday, buy some gifts for parents and loved ones are good ways to recharge your batteries and share the joy around.

Sometimes share and you will received more. However, do it in moderation. For some people, they may feel that their bonus is small, but when they add up in 10 years, it may be quite a substantial sum.

Pay off debts

Some folks might be incline to put these substantial amount to the stock market, however, I would suggest assessing the debts that you currently hold to see whether you are able to reduce them.

You can take up debt clearing methodology like Debt Snowball to substantially reduce the amount of interest paid.

Your returns from the markets may not be certain, but by paying down debts, you are certain that you will be reducing your outflow, which is indirectly a gain.

Get an education before investing

Some of my friends would rather put their money into the stock market and learn from it directly. There are pros and cons to it but I do see it as more cons.

The end state is they normally do more harm themselves to their portfolio rather than good.

Why not pick up $100 worth of books or education session? treat that as a commission. The difference is that you arm yourself with something that you can use over and over again ad possibility prevent you from making bigger mistakes.

An annual dollar cost averaging

Should you make it this far and still think it’s a good idea to invest your bonus then all the best to you. My take is that you do not have to split the amount out. If your bonus is rather consistent, what happens when you dump a whole lump sum is that if you buy at the market peak your next bonus may be bought at a discount.

Why I would not invest all my bonus

I made a conscious decision not to save as much of my bonus as possible. I made a 10 year goal that I may talk about in a later article.

The truth is that your life goals change and when your income progress to a certain state, you need to set aside money for other goals and that you need to share the wealth around more.

Its not easy to adjust but 30% of it will go to my family, other objectives and higher education.

How do you guys intend to use your bonus?

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Should you stop dollar cost averaging stocks in this correction / bear market?

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So we know that you have a Philips Share Builder plan from Philips Securities, which essentially lets investors dollar cost average into certain Singapore blue chip stocks.

Now this plan is good in that

  1. It acts somewhat like a force saving making you put aside the money
  2. It ends up as odd lots (since each time you buy so little shares) making it difficult for you to sell it off
  3. Takes the market timing out of the equation

Now note you can stop your DCA anytime. Which bring us to this article.

I have a relative who likes this form of structured investing or investing based on a portfolio manner. The worst thing I did was to seduce him into the benefits in investing in telcos such as Starhub and Singtel.

So we know the market hasn’t done very well recently and my relative, being a student of economics sees that there are just too much troubles out there.

The best time to invest is when the trouble clears.

So he was DCA into Singtel all this while after my persistent advocation but recently I understand he have stop DCA. The reason?

It is stupid to DCA when the trend is going down

Now this is interesting for me because there is no correct or wrong answer here.

Recession Sturdy Business Model

We have a DCA candidate here that have a strong utility like business model. It is unlikely to falter as in a recession, your handphone is your business and communication asset. You will still need this service.

Though profits may be affected, they are unlikely to go bust anytime soon. Lack of business will actually bring down capital expenditure.

Consistent trading price range

Since July 2009, it has been in a consistent trading range, the lowest $2.66 the highest $3.20. A channel of 16% drawdown maximum.

Price is not far off from bottom

The lowest price reached, discounting the spike at the end of 2009 recession was $2.30. That is a maximum of 25% drawdown

What are the likely scenarios

Now here are 4 scenarios that I can see drawn out and how DCA will be affected

  1. In the green arrow, the price will trend upwards. Rather unlikely, as there are not much near term catalyst. In this case stopping your DCA will make you missed out on most gains. Yes, you can always restart it, but we will come to this later. You have to be nimble though.
  2. On the opposite end you have the red arrow. This will be like the 2009 drop, where even all the good stocks drop in a matter of 2 months. If you stop DCA, you are likely to missed out on such a drop. You are likely to suffer from either paralysis (because you think it is likely to continue to go lower) or you will see this as an opportunity to kick start your DCA again.
  3. The third scenario is the one my relative things, which is the orange arrow. It is a long drawn draw down. And stopping DCA means you do not suffer much capital loss. However, it is likely that in such a scenario, you get a lot of false hopes when you can kick start your DCA again.
  4. The last scenario is in the blue arrow. This is when the bear market comes and goes, and Singtel still ends up in the same range! If you look at the market it is in a 13-15% correction, many stocks have fallen, yet Singtel is still at the same place. Stopping DCA will mean waiting and waiting and waiting.

What is my take on this

Essentially,

  1. I think my relative is market timing. Like me he thinks he can outsmart the market. He will have to get his DCA right.
  2. He is stopping his force savings plan. Is that desirable?
  3. He is doing excessive work monitoring the market. Was this the original purpose of DCA?
  4. The bulk of the move takes place in probably 2 weeks most of the time. He is equally likely to missed out on big gains and big fall.
  5. Since 2001, Singtel have not cut its dividends. 70% of its returns are in the form of dividends. Will it make sense to missed out on these dividends?

What do you guys think?

I am sure there is no right or wrong answer to this but perhaps we can take this as a case study and put yourself in the shoes of my relative

  1. Tell me what you are likely to do
  2. Why do you take that route

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