Buy and hold, PCA or trade?
Question: The stock market is falling like a rock. What is the best strategy to take? Do I just stop with what I have and hold until I will need funds? Do I do peso cost averaging as recommended by many advisers? Or, do I start to buy and sell over short periods of time? —asked at “Ask a friend, ask Efren” free service available at www.personalfinance.ph, Facebook and SMS.
Answer: To answer your question, let us first look at the historical performance of the Philippine Stock Exchange index or PSEi. We will need to start from 1987 or after the unified index was implemented.
From 1987 to 2017, the PSEi rose from a yearend closing of 816.21 to 8,558. If we were to compute the simple growth rate or return on the PSEi over the 30-year period, it would be an astonishing 949 percent. However, the better measure would be the compounded annual growth rate as simple growth does not take into consideration the time value of money (i.e. money yesterday is worth more than money today).
On a compounded annual growth rate, the PSEi returned only 8.1 percent over 30 years. While the growth rate is higher than bonds, the growth rate for the PSEi is not a whole lot higher considering all of the attendant risks that go with stock investing.
But what if someone did peso cost averaging (PCA) every yearend in the PSEi? Using yearend returns of the PSEi for the same period and taking out transaction costs in buying and selling stocks, PCA would have produced a growth rate of only 8.63 percent a year compounded. This is not a lot better than the buy and hold strategy but it is the more realistic strategy.
In computing for the PCA return, we assumed a yearly investment of P100,000 over 30 years or a total of P3 million. The buy and hold strategy assumes the P3 million would have been invested in 1987. In reality, not many can invest a huge amount one time.
While PCA does not provide a substantially higher return than buy and hold, it is the more affordable strategy for the common investor.
What about trading, or buying and selling over short periods of time? If we were to put a positive return of 40 percent a year as the signal to take profits and a negative return of 10 percent a year as the signal to sell, our simulations show the return over the 30-year period jumps to 11.8 percent a year compounded.
Professionally managed funds engage in trading simply because they have the “S”ize of funds to have access to all the information and in-depth research, the “E”xpertise and experience, as well as the “T”ime to do stock trading. Such funds are all SET to invest directly. The common investor will lack in one or more of these to trade well in the stock market.
Yet, there is a better strategy than all of the three you are asking about. It is to just do PCA on professionally managed funds. Examples of these are mutual funds, unit investment trust funds, single pay variable unit-linked insurance and investment management accounts with trust departments of banks.
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