Removing emotion from investing

8 June, 2017

Volatile markets can be stressful to some, but the wise and unemotional investor knows that he or she can still make money, or reduce losses, by using a very easy and time-tested investment strategy.

Volatile markets can be stressful to some, but the wise and unemotional investor knows that he or she can still make money, or reduce losses, by using a very easy and time-tested investment strategy.

Dollar-cost averaging entails investing a consistent amount of money each month in a specific investment (or investment portfolio) regardless of market volatility. Using this systematic, disciplined approach to investing has been statistically proven to provide enhanced returns as compared to the typical investor, who irregularly invests lump sums.

Why does this strategy work? Essentially, it forces investors to buy low. Though buying low and selling high is a fundamental investment strategy, many investors simply do not have the investment discipline to invest when the market is in free-fall (low), or sell when the market is reaching for the stars (high).

The advantage of this investment strategy is predicated on the basis that investors acquire more units when prices are low, and fewer units when prices are high.

Still, the fact of the matter is that by far most investors buy and sell on emotion. When there is a big run-up in the market, everyone wants to buy-in (referred to as following the herd, or the “herd mentality”). When the market is on a tear, investors should be looking at selling, not buying.

Then when the market starts dropping, people want to sell – again the exact opposite to what they should be doing. When prices are discounted (i.e. market values in decline), it’s time to buy, not sell. I have often quoted Warren Buffet on this fundamental investment principle. In his words: “I’m greedy when others are fearful, and I’m fearful when others are greedy”. Translation: Buy low, sell high.

Put another way, I often apply the following analogy to help my clients gain a better grasp of how to deal with a falling stock market… I ask what they would do if the housing market in Greater Moncton declined by 20% in one year. “Would you rush out to sell?”, I ask. “No”, they wisely exclaim. “I would wait for the housing market to recover before I’d suffer a loss like that.” I say: “Bravo, that’s precisely how to act when the stock market tumbles”.

Why dollar cost averaging makes sense

Dollar-cost-averaging works because the same amount of money is invested on a regular basis (monthly, quarterly, etc.), regardless of the share price. Thus, when the share price is high, less shares are purchased. Conversely, when the share price is low, more shares are purchased. Essentially, it ensures that the average price paid throughout the investment period is the lowest possible price, unless one had the good fortune of knowing to invest the full sum precisely when the share price was at its lowest. Since market timing is impossible, dollar-cost averaging ensures that the average cost/share is minimized.

For example, let’s say at the beginning of this year, you put $100,000 all at once into a stock priced at $100/share. By the end of the year, the stock has declined to $70/share, resulting in a 30% loss in value, or $30,000.

Instead, what if you evenly distributed your money over the course of the year? Let’s say you decide to invest $25,000 each quarter. When the stock is down, you end up purchasing more shares, and when it’s up, you purchase less shares. This increases the number of shares you purchase and also decreases your average price/share. See the following chart:

 

Q1 – $25,000 at a share price of $100 (250 shares purchased)

Q2 – $25,000 at a share price of $90 (277.7 shares purchased)

Q3 – $25,000 at a share price of $80 (312.5 shares purchased)

Q4 – $25,000 at a share price of $70 (357.1 share purchased)

 

Total shares purchased: 1,197.3

End price: $70

Market value: $83,811

 

Instead of having lost 30% or $30,000 on your initial investment, you’d have lost only 16.2% or $16,189 on your initial investment.

Let’s take another example. Here, the stock starts the year at $100 per share, and then finishes at $90. If you bought at the start of the year, you’d have lost 10% or $10,000.

However if you employed the dollar-cost averaging strategy, based upon the chart below you would have actually made money, notwithstanding that the stock ends the year down in price. At the end of the year, you would have made $4,580, compared to a $10,000 loss under the lump sum scenario. See the following chart:

 

Q1 – $25,000 at a share price of $100 (250 shares purchased)

Q2 – $25,000 at a share price of $90 (277.7 shares purchased)

Q3 – $25,000 at a share price of $70 (357.14 shares purchased)

Q4 – $25,000 at a share price of $90 (277.7 share purchased)

 

Total shares purchased: 1,162

End price: $90

Market value: $104,580

 

The bottom line is that with dollar cost averaging, you can reduce market risk and build your investments over time, regardless of where the market is going.

Investors typically buy and sell at the wrong time based on emotion. They are buying and selling based on what the market is doing, and – as much as many investors would like to argue otherwise, no one can predict what the market will do. Fortunes have been lost by those who have tried. Thus, dollar-cost averaging forces investors to buy low and maintain discipline in the face of volatile markets.

Bottom line, the best time to be investing is when the market is dropping. Why is this so hard to do? Because it goes against common sense and emotion. Thus, on the 8th day God created financial advisors to steer you through the emotional haze and investment maze of financial and investment principles.

Again, and as always, please do not hesitate to contact the writer to ensure the strategy you embark upon is the one best suited to help you meet your particular retirement objectives.

 

Joel Attis

joel@attiscorp.com

Joel Attis is a Senior Financial Advisor with AttisCorp Wealth Management and IPC Investment Corporation. Comments or questions may be submitted to Joel at joel@attiscorp.com, or he may be reached at 855-1155.

Securing your Family's Future

Following the advice of a trusted advisor is shown to be a significant factor in building wealth and achieving investment success. Our team can provide sound advice and a Personal Wealth Management Strategy™ to guide & assist you & your family at any stage of life.