Last week, the US stock market, represented by the S&P500, declined 3.5% which made it the worst week since 2016. However, the market is still up 2.5% for 2018 after a great 21% gain in 2017. Some of the analysts expect the market to declines more in the next few days and weeks hence I wanted to write this article to warn Wealth Heights’ friends of a very common mistake to avoid in the middle of any challenging market circumstances. Unfortunately, many investors tend to follow the crowd by chasing winners and running away from losers.
Even Mutual fund managers do the same mistake and therefore 96% of actively managed funds failed to beat the market. It is a human nature to want to follow the pack and not to miss out on anything. The Princeton economist Burton Malkiel said “Emotions get hold of us and we, as investors, tend to do very stupid things”. We tend to put money into the market and take it out at exactly the wrong time. More money went into the market at the peaks of 2000 internet bubble and of 2007 financial crisis then, unfortunately, the money came pouring out at the bottoms of Q3 2002 and Q1 2009.
This is exactly what I call the Stocks BankRupcy Cycle, see the chart below, when people repeatedly buy at the top driven by their greed and sell at the bottom out of fear. This is the one mistake all investors must avoid to make money in the stock market. If you think you can time the markets, you are wrong. Even the best in the world can’t do it every time because there will always be factors they can’t predict. Peter Lynch said “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, that has been lost in corrections themselves”.
So, what is an answer to the dilemma of timing? Benjamin Graham, Warren Buffet’s mentor and teacher, told us one of the answers which is Dollar-Cost averaging.
Dollar-cost averaging (DCA) is an investment technique of buying a fixed dollar amount of an investment on a regular schedule, regardless of the share price. The ultimate benefit of DCA is avoiding your greed and fear emotions to interfere with your investment decision and accordingly helping you to systemically avoid the bankruptcy cycle. It provides a timing diversification which reduces risk significantly. In DCA, the investor purchases more shares when prices are low and fewer shares when prices are high. The premise is that DCA lowers the average share cost over time, increasing the opportunity to profit. The DCA technique does not guarantee that an investor won’t lose money on investments. Rather, it is meant to allow investment over time instead of investment as a lump sum.
Dollar-Cost Averaging Example
For example, assume an investor invests $1,000 on the first of each month into SPY ETF (S&P 500 index ETF). Assume that over a period of five months, the share price of SPY on the beginning of each month was as follows:
- Month 1: $20
- Month 2: $16
- Month 3: $12
- Month 4: $17
- Month 5: $23
On the first of each month, by investing $1,000, the investor can buy a number of shares equal to $1,000 divided by the share price. In this example, the number of shares purchased each month is equal to:
- Month 1 shares = $1,000 / $20 = 50
- Month 2 shares = $1,000 / $16 = 62.5
- Month 3 shares = $1,000 / $12 = 83.33
- Month 4 shares = $1,000 / $17 = 58.82
- Month 5 shares = $1,000 / $23 = 43.48
Regardless of how many shares the $1,000 monthly investment purchased, the total number of shares the investor owns is 298.14, and the average price paid for each of those shares is $16.77. Considering the current price of the shares is $23, this means an original investment of $5,000 has turned into $6,857.11.
If the investor had invested all $5,000 on one of these days instead of spreading the investment across five months, the total profitability of the position would be higher or lower than $6,857.11 depending on the month chosen for the investment. However, no one can time the market. DCA is a safe strategy, due to timing diversification, to ensure an overall favourable average price per share.