“How to gain from market downturn”, featured in Money, Life & Times, New Sunday Times, on 21st August, 2011
After the recent crash in the global stock markets, most people would have become bearish about the market, feeling it would be best to avoid the market for now. Interest in making investments is at an all-time low, despite it being a good time to buy low and sell high later.
It’s hard, if not impossible, to convince ourselves to invest when everybody is panicking. We may think that since the market drop is so sharp, it may go down even further. If you hold such view, there’s an investment strategy that should perform well in this bear market: dollar-cost averaging.
How it works
Dollar-cost averaging is a strategy to invest a specific amount of money in the market at routine intervals (monthly, quarterly, half-yearly or yearly).
For example, instead of investing a lump sum of, say, RM60,000, you invest RM5,000 a month over one year. By doing this, you average out the cost of investments over an extended period of time. This is to make sure you don’t invest all your money at the peak of the market.
This strategy performs especially well in an extended market downturn as you will keep buying at lower and lower prices until the market recovers.
For example, you invest RM1,000 in an equity unit trust fun at RM1 per unit. So, you end up with 1,000 units. The following month, you invest another RM1,000 in the same fund, but because the unit price has dropped to RM0.50, you end up with 2,000 units.
What is the average cost of all your units? If your answer is RM0.75, you’re wrong. That’s because you have used the arithmetic mean (RM1 + RM0.50 / 2 > RM0.75). You should use the harmonic mean.
Hear’s how to calculate that: Your total investment is RM2,000 and you have 3,000 units of the fund. Divide RM2,000 by 3,000 units and the average cost is RM0.67. This means by using harmonic mean calculation, dollar-cost averaging gives a lower average cost.
Effective Strategy
Let’s take an example that is closely related to the current market scenario. You’re bearish about the market and think it will go down for another six months before it recovers. We will see how dollar-cost averaging works based on this assumption.
From Table 1, if you invest RM1,000 a month for the next 12 months, you would have invested RM12,000 and accumulated 25,648 units at the end of the period. At RM0.80 (which is lower than the priginal price), your investment value at the end of the period is RM20,518 (RM0.80 x 25,648 units).
This means you would have gained RM8,518 (RM20,518 – RM12,000). That’s a 71 per cent gain over 12 months, despite the fund price beaten down by as much as 78 per cent (RM0.90 – RM0.20 > RM0.70, then divided by RM0.90 > 78 per cent). That’s why dollar-cost averaging works well if you believe the market will continue to go down.
Why it works
Dollar-cost averaging helps us to overcome our emotions when it comes to investing, whether it’s fear or greed. We’re always tempted to invest when the market is high and so we end up buying high instead of buying low. By using dollar-cost averaging, we’re programmed to buy less units at higher prices.
And when the market crashes and the prices are low, we don’t feel like investing because of fear. By using dollar-cost averaging, we end up buying more units at lower prices.
For this strategy to work, invest a specific amount of money at specific intervals, say RM500 a month or RM1,000 every 3 months. It does not matter which interval, what’s important is it’s done consistently. The idea is to invest at each interval no matter the market condition.
How to make it work better
Dollar-cost averaging works best when you invest in investments whose prices are highly volatile (move up or down in big quantums).
An investment that is highly volatile is often thought as a risky investment. But this risk plays to your advantage when you apply dollar-cost averaging because this strategy is based on efficient accumulation of investment units. When a particular investment sees a big drop in price, you get to accumulate more units. The bigger the drop, the more units you accumulate, so your accumulation is more efficient.
In comparison, if you invest in an investment that has low volatility, the drop will be very small and you only accumulate few units, so your accumulation is less efficient.
This means when applying dollar-cost averaging, you should go for equity funds and avoid money market funds, bond funds or balanced funds.
Warning: Don’t use an individual share for this strategy. When the price of a share is in a sustained downward trend, there must be a reason for it and there;s no assurance that the price will recover. For dollar-cost averaging to work, the price of your investment must recover.
Start implementing it
To benefit from dollar-cost averaging, you have to apply it. Along the way, you may not feel like buying when the price of your investment has dropped further, or you may not keep to the plan because of your hectic schedule. Well, don’t let anything stop you. Follow the strategy and you will make the gains.