Peso cost averaging in crises
Question: So, which is the better strategy to take, one time big time investing or peso cost averaging? Asked at “Ask a Friend, Ask Efren” free service at www.personalfinance.ph, SMS, Viber, Twitter, LinkedIn, WhatsApp, Instagram and Facebook
Answer: One view is that stocks around the world were pummeled by the pandemic and resulted in one of the worst performances in history. The opposite view is that the huge drop in prices presented an opportunity to make short-term profits on whatever rebound that may ensue.
What is clear though is that the pandemic did not lead to the first major downturn in stock prices. In fact, history is replete with major crises that sent prices tumbling. Wikipedia lists more than 50 from the Tulip mania bubble in 1637 to the Wall Street Crash of 1929 to the present COVID-19 pandemic.
Crises are here to stay, and experienced investors know that continuous investing in both the highs and the lows of markets is the best strategy to weather such crises. The strategy is called cost-averaging.
Cost-averaging simply means that you invest a fixed currency amount periodically. When prices are high, your fixed currency amount buys fewer investments. When prices are low, your fixed currency amount buys more investments. And over time, you are likely to have a better average cost than if you were to invest everything at the start or time the market.
Consider the Philippine Stocke Exchange index (PSEi)from 2007 to 2019. If you had invested all of P1.2 million at the end of 2007, the value of your investment by end 2019 would be a whopping P5 million. And if you go by the PSEi Total Return Index (TRI) (i.e. the PSEi with dividends reinvested), your P1.2 million at the end of 2007 would have grown to P6.6 million by end of 2019. The implicit effective annual returns would be 6.62 percent under the PSEi and 9.42 percent under the PSEi TRI.
But wait, many of us do not possess that huge chunk of money to invest with at the start. The more viable alternative is periodic investing through cost-averaging.
So, if you had P100,000 to invest at the end of each year from 2008 to 2019, wherein your total investments would also amount to P1.2 million, the value of such investments would amount to P2.2 million if you go by the PSEi and P2.6 million if you go by the PSEi TRI. The implicit effective annual returns will even be much higher at 8.71 percent under the PSEi and 11.21 percent under the PSEi TRI.
Of course, people with a trader’s mentality will say that they can probably outperform if they just time the market. The problem with timing the market is that the probability of hitting the right buy and sell prices is exceedingly small.
You will know when a stock price is at its highest after the fact simply because you will need the subsequent day’s stock price to confirm that conclusion. By then, you will have missed selling at that supposed high price. By the same token, you will need the subsequent day’s price to confirm that indeed a certain stock price is the lowest. By then, you will have missed buying at the supposed low price.
That is why advocates of cost-averaging say that instead of trying to do the impossible, why not just do it the easy way by buying a fixed amount periodically. If your holding period is long enough (i.e. at least five years), chances are you will withdraw part if not all of your investments at a greater profit.
It is also said that when it comes to investment performance, 92 percent of the time is it generated by asset allocation, 5 percent of the time by security selection, 2 percent of the time by timing, and 1 percent of the time by sheer luck. That is why they say, “Time in the market is much more important than timing the market.”
One last thing, if your income is growing, do not just be happy with cost averaging. Grow your periodic investments as fast as your income growth. That would be the wiser way of investing periodically.
Stay safe and healthy. INQ
Efren Ll. Cruz is a registered financial planner of RFP Philippines, seasoned investment adviser, bestselling author of personal finance books in the Philippines. Join our Yaman Coach free webinar series. For details, email [email protected]. To learn more about personal financial planning, attend the 87th RFP Program this January 2021. To inquire, email [email protected] or text at 0917-.6248110
Copyright 2020 Efren Ll. Cruz, RFP. All rights reserved. This material may not be published, broadcast, rewritten or redistributed without the prior written consent of the author.
