Building wealth with peso-cost averaging
Burton Malkiel, who wrote the classic finance book “A Random Walk on Wall Street,” once said the winners in the investment game are those who stay the course and put in new money regularly, no matter how uncertain the outlook might be.
Malkiel suggested that, instead of putting all your money in a lump sum, investing a fixed amount on a regular basis over a period can help you avoid the risk of buying a stock at the wrong price.
This cost averaging strategy, which was known as formula investment plan during the Great Depression, requires you to invest the same amount every time, regardless of the stock price.
Because the investment is fixed, you can buy more shares when the market goes down and fewer shares when the market goes up, enabling you to lower your average cost over time.
In uncertain times, when there is too much volatility in the market, applying a peso-cost averaging (PCA) strategy may seem like a good idea because it does not only help you spread out your risk, but also keep your emotions in check.
If you hold on to this discipline, by following your plan of investing consistently, your investment should eventually pay off when the market recovers in due time.
However, because of the passive approach of this strategy, you may miss out some opportunities to make large gains.
For example, if we invested P10,000 weekly at the start of 2007 during the financial crisis in the stock of Universal Robina, we would have made a gain of 177 percent by the end of 2010.
But if we saved the money and waited for opportunity to accumulate the stock at its historical lows, we would have gained 535 percent, which is roughly three times better.
We would also get the same results if we invested in other blue-chip stocks following the same assumptions.
Let’s say we bought Meralco following the PCA strategy, the gain would be 144 percent but with lump sum strategy, the gain would be three times higher at 449 percent.
If we invested in Jollibee at that time, we would earn 75 percent under PCA, but we would get 169 percent under lump sum approach. The same also with Ayala Land, which would yield 51.8 percent with PCA, but if we timed the investment, we would get 236 percent.
While the PCA strategy may look appealing, this is not for everyone.
During this time of crisis, this strategy maybe ideal for those who don’t have enough savings to build an investment portfolio in the stock market.
People who are new to stocks and do not have time to monitor their investment daily may benefit from this strategy because they can use it as a form of automatic savings and investment.
But if you have the time to learn the market, the willingness to risk and the extra cash, it does not make sense to use PCA because this strategy will limit your ability to maximize your returns.
For example, when you are already committed to invest in a stock under PCA, it may not be easy for you to switch to other stocks or reduce your investment should there be any significant changes in the fundamentals of the company.
In lump sum approach, you can be flexible and do anything to keep your investment on track. Note that you don’t need to use your entire investment budget in a single transaction under lump sum.
You can manage your buying by timing your execution in several transactions at different prices and complete it in few days. Your objective is to get the lowest average price possible.
Peso-cost averaging makes sense only to people with lower risk tolerance who want to leverage the stock market as a form of savings to get higher returns. INQ
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 84th batch of RFP program this August 2020. To register, email [email protected] or text at 0917-9689774.
