How this simple investment rule can make all the difference
Peso-cost averaging actually came from dollar-cost averaging.
Whatever the currency, the basic tenet of cost averaging is to invest a fixed amount of money regularly[ELC1] —monthly, quarterly—in a basket of financial securities. Example: You decide to invest PhP2000 in a fund every month for three years, 2017, 2018, 2019. Cost averaging is achieved when your investment averages out no matter what the movement of the market it. This is because when the prices of such securities move up, you as the investor end up buying less of them. When the prices of the same securities move down, making them a bargain, you end up buying more of the securities.
For instance, if the fund price was down to PhP200.00 in 2017[ELC2] and you bought PhP2,000 worth per month, you would have 10 shares/mo. But in 2018, it doubled to PhP400.00. With your PhP2,000, you would have only gotten 5 shares/mo. What if in 2019, it went back to PhP200.00. You would have gotten 10 shares/mo again. If you add them up, you’d have an average of 8.33 shares/mo. You achieved the middleground. Even if the market went down in 2019, you did not lose a lot because the cost averaged.
Cost averaging is a strategy fostered by behavioral economics, that of assigning a simple and previously existing rule in the brain, in this case for investing automatically and quickly so that the brain operates efficiently and effectively. Moreover, trying to buy at the lowest point and selling at the highest price are impossible to do because you will only know whether a certain price is either at the highest or lowest point after the fact. Trading the market is also time consuming and energy sapping, especially if it is not the goose that lays your proverbial “golden egg.”
Simple rules in investing are not uncommon and have been offered by some of the greatest investors and traders of our time. One of Warren Buffett’s greatest rules is to not monitor the price movements of the investments he made. He does this because prior to making any investment, he will pore over financial reports to make sure that such investments’ intrinsic value are much higher than their current market price.
Jessie Livermore, [ELC3] perhaps the world’s greatest trader, says that once an investment’s price falls by 10% from its cost, sell it with no questions asked. Then get out of investing for a while to regroup. Livermore’s rule makes sense in that a 10% loss would need an 11% return just to bounce back to the original investment cost; and a 50% loss will need a 100% return just to do the same. These simple rules are called heuristics, which are nothing more than rules of thumb, educated guesses, intuitive judgments, and plain common sense. Cost averaging is one of them.
Now, the annual compounded return of the Philippine Stock Exchange Composite index (PSEi) from 1987 to 2017, is only 8.1%. This return hardly seems enough to compensate for all the ups and downs that go with stock market investing.
Trying to buy at the lowest point and selling at the highest price are impossible to do because you will only know the prices, after the fact.
Presumably, cost averaging will provide a better strategy. But if you did cost averaging on the PSEi over the same period, your return would have improved only marginally to 8.7%. So, do the numbers disprove the effectiveness of the cost-averaging strategy?
Not really. The Philippine stock market, with all its wild swings, is not yet an efficient one and as such requires active trading and not passive investing. Proof of this is that equity funds are capable of outperforming the PSEi and returning more than just 8%.
In a simple back test exercise where we take profits on the PSEi when it hits a yearend return of 50% and cut losses when the yearend unrealized losses touch 10%, the returns on cost-averaging already improve over 11%. Do note that the trades in the back test were executed only once in each year, whereas the ups and downs of the PSEi occurred more than once in a year.
So, what is the better strategy to take, especially if investing is not where you earn the bulk of your money? It is to do cost-averaging on actively traded but professionally managed funds like variable unit-linked insurance policies, mutual funds, and unit investment trust funds. These so-called pooled funds have professionals on board who will do nothing but manage your hard-earned savings for you, day in and day out.
Investing need not be complicated to be profitable.
[ELC1]Periodically is the more precise and technical term as it more closely refers to units of time like monthly, quarterly or yearly. But it is up to you to decide.
[ELC2]This paragraph and the insertion of the Example above would best go together. But I purposely did not provide the example because the article is not about cost averaging but a better strategy to it. Perhaps another article on Peso cost averaging would be better.
[ELC3]I meant to say touted as because I do not want to come out as making the judgement