Sunday, May 04, 2008

DCA: When the market down, BUY MORE!

Value investors rejoice when the markets go into correction mode. Bcos that means they can pick up good businesses at bargain prices. Logically and intuitively, this makes perfect sense, but somehow our ape-evolved brains are not wired to think that way.

When the markets have rallied for some time and it goes down, we panic. When they subsequently rebound, we curse and swear that why didn't we buy more during the correction. And when the markets go into correction mode for 3 years, we get totally not interested in the markets. Many don't ever return to invest, even though it's the best chance they got against inflation.

So some have come up with a method to counter this flaw and help us invest wiser. It's called Dollar Cost Averaging or DCA for short. It simply means that you put the same amt of money to buy stocks/UT/index funds etc at fixed time periods.

The logic is that although you lose money when the markets go down, bcos you put the same amt again after it has declined, you buy more of the stock/UT/index fund, and over time, since all markets will rise, you will earn the market average return of 8-10%.

However, one must be wary that it's also detrimental if you cut it too thinly ie if you DCA every mth, you end up paying a lot of commission bcos sometimes for UT there is a sales charge for every transaction, and for stocks the bid-ask or the $20 transaction cost kills you. This is what brokers will recommend bcos it generates more commission dollars, so beware!

I have 2 recommendation to improve on DCA that I hope will help most pple.

1) This is just reiteration. Don't cut it too thinly, ie maybe at least once a year and buy more at one go, like maybe roughly $10k at one go. Imagine if you DCA every mth at $1k. You pay 2% sales charge, or you pay $20 on transaction at the brokerage, which is also 2%, you are giving the return away, investment earn only 8%pa on average. So it has to be a huge amt to offset these costs. At $10k, the $20 becomes 0.2% + some bid-ask which ends up maybe like 0.8% or something. Alas, for UT or funds that charge 2%, too bad, $10k you still pay 2%. So avoid funds with huge sales charge.

2) Buy more when the markets are down. Instead of DCA-ing the same amt. You can buy more when markets are down ie. in 2000 you really DCA a minimum amt, 2001 you increase your DCA to 120%, 2002 to 140% of original, 2003 another increment etc. Of course, on hindsight, that's easy. We knew what happened already. How about now? Do you increase your DCA amt next year if the markets are down? Chances are if it goes down in 2008 it's gonna go down in 2009 as well right? But I guess one simply has to strengthen the will to increase DCA when the markets are down and lighten up when the markets are rally. That way, it will enhance return and help you hit 8-10%pa over the long run.
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