Even Out Risks To Grow Nest Egg Faster

Foreword from ShareInvestor

This article “Even Out Risks To Grow Nest Egg Faster” by Lorna Tan was first published in The Straits Times (INVEST) on 22 Jun 2008 and is reproduced in this blog in its entirety.

Last month, I shared about how I like to “pay myself first” by having money channelled automatically from my payroll and deposited straight into regular savings plans.

A closely related concept is “dollar-cost averaging”, which could be a part of such plans, if one intends to enter the investment market at regular intervals.

In fact, many financial experts prefer dollar-cost averaging to lump-sum investments – particularly when protecting against paying too much for investments in a volatile market.

This is how dollar-cost averaging works.

The same dollar amount is invested at regular intervals, say monthly, into a diversified investment portfolio. This arrangement holds regardless how the market is doing. As a result, the price paid for the shares or unit trusts is averaged out.

This means more shares are bought when prices are low and less when prices are high.

The natural question that comes to mind is how spreading one’s investment over time, via dollar-cost averaging, gives you better results than investing a lump sum in the market.

Let’s examine which method is better. 

Method 1: Lump-Sum Investing

Doing this effectively means timing the market by trying to buy low and sell high.

It’s great if one succeeds but in reality, most people fall on their face. Such investors lose money primarily because their greed and fear result in an inaccurate reading of the market.

Studies from US-based research firm Dalbar have shown that those who attempt to anticipate market movements usually run the risk of exiting and entering the market at the wrong times.

For example, let’s assume you have $10,000 and you want to purchase stock A, whose price recently fell to $10 apiece. Having seen it hit a high of $15 a share previously, you think this is a good time to buy, and go on to purchase 1,000 shares.

A month later, the shares dip to $5 apiece, but you decide to hang on to them. Ten months later, stock A remains at $5. You now have a paper loss of $5,000.

Method 2: Dollar-Cost Averaging

This method entails dividing the principal sum of $10,000 into equal amounts of $1,000 and investing the smaller sums every month for 10 months, regardless of how the market is doing.

Let’s say that the price of stock A remains at $10 for the first five months and falls to $5 a share in the next five months. Using dollar-cost averaging, you would buy 100 shares with $1,000 in each of the first five months and 200 shares with $1,000 in each of the next five months.

As a result, you are able to buy more shares when the price is low and this means owning more shares overall.

At the end of 10 months, instead of having 1,000 shares, as would have been the case if you had invested a lump sum, you now have 1,500 shares.

And even though the share price is down to $5 apiece, your holdings are worth $7,500, instead of the $5,000 they would have been worth if you had done a single outright transaction. This translates into a smaller loss of $2,500, compared with the $5,000 you would have lost if you had done a lump-sum investment.

With dollar-cost averaging, you are able to limit your loss when the market is trending down. This method also eliminates the risk of market timing and creates the discipline to stay invested in the market at all times.

These reasons explain why investors are better off using dollar-cost averaging in the long run.

New Method: Value Averaging Plans

Recently, wealth management firm dollarDex introduced value averaging plans (VAPs) which take dollar- cost averaging a step further.

This is how they work.

With VAPs, the aim is to automatically take advantage of market volatility by investing more when markets are lower, and less when markets are higher. In volatile conditions, this can mean higher portfolio returns.

At the heart of these plans is a mathematical formula which guides the investment of money over time into a portfolio.

While dollar-cost averaging relies on a fixed investment amount in each period, value averaging dynamically adjusts these amounts in response to market changes.

Value averaging works on the principle that you would want to increase your portfolio by a certain value over time, for example, $1,000 each month.

Some of this value could be in the form of an incremental investment each month, perhaps coming from your bank account via GIRO. Some of it could come from gains made through the existing portfolio during bullish markets.

For example, in a good month, your current portfolio might rise in value by $600. A VAP would recognise that you need to add only $400 to your portfolio from your bank in that month to keep on track for the $1,000 of value to be added.

Conversely, when markets are down and your portfolio is down by, say, $250 that month, the VAP will recognise that you need to add $1,250 of fresh money to your portfolio to stay on track.

The net result is that when markets are trending up, your bank account is called on less. When markets decline, your fresh investments increase. It’s simply a twist on the idea of buying more when prices are low.

Most regular savings plans allow you to invest with as little as $1,000 initially and $100 thereafter. A good option is to do both lump-sum investing and dollar-cost averaging by starting with a small lump sum and topping up regularly.

Investing is not so much about timing the market but about time in the market. So invest regularly, with a long-term view and stay disciplined.