An investment strategy is a blueprint for constructing a building. We have previously written an article on Dollar Cost Averaging vs Lumpsum Investing, you can read it here. First, you must be able to save in order to invest. If you are unable to put a substantial income away, you will not be successful. Second, you must be able to execute. The discipline of investing mandates when everyone is panicking selling, you must keep your cool and continue to purchase in a far larger amount than during normal times.
The market is filled with risk but over a very long period, the annualized return is less varied because the randomness of the return causes them to average out. Meaning, over the long term, you will win money or have a positive return in the stock market, the longer you remain in the market, the more definite your outcomes will be. If you need to access your funds within the next 5 years or sooner, it may be reduced due to market loss, funds invested for longer periods are less likely to experience a loss.
Corporate Bonds are risker than stocks because they experience the duration risk as per long term Treasuries bills and on top of that they are linked with default of corporations. The relevant number to project into the future seems to be a 7% difference between common stock and government bond returns. In 1992, government bond rates are as high as 7-8%, this results in expected returns on the stock market to be around 14-15%. Judging based on the present situation with a low level of interest rate, the expected returns on the stock market in the future will likely be lower between 7-9%.
We cannot predict the market, knowing when the market has peaked or how to differentiate between a market correction from the start of a bear market. You will never know beforehand when to move your money in and out of the market. We all want to buy high and sell low but many times do the opposite.
We have mentioned about Passive Investing earlier, it is not meant to beat the market but just survive in it and reward for the risk incurred. Mere survival will provide rewards and grow with compounding effect over a very long period.
Dollar Cost Averaging
Dollar Cost Averaging (DCA) is a simple strategy, invest the same amount of money each time period, regardless of the price. I have advocated this to my clients previously for those who had invested with me. You will accumulate wealth over time through a consistent inflow of investment money at a steady rate.
DCA creates discipline by increasing exposure to market risk and return over time, this removes timing, near peak investment. DCA is an automatic market timing which eliminates the need for active market timing. When money is invested regularly, the average cost of shares is leveled out over time. DCA helps to provide time diversification and reduce investment risk. The strategy is to invest a fixed amount at regular intervals, regardless of the market price. You receive fewer shares when the prices are high and more shares when the prices are low.
Problems with Dollar Cost Averaging
It does not make sense to invest the same amount over a very long period because the same amount in the future is eroded by inflation. It is important to increase the investment amount gradually over the years.
After catering to inflation, there is still another problem, the stock market grows faster than inflation over time. This means that we are pouring a lot of money at the start of the investment journey and very little money towards the end. The new money invested becomes more meaningless with respect to how much value they can buy in the fast-growing stock market.
This means that the fixed amount of dollar cost averaging investment needs to increase by a steady amount over the years, the invested amount needs to grow with the long-term growth in the level of the market. This is a growth-equalized variation of the strategy.
Value Averaging is a formula strategy that is more flexible and achieves a lower average per-share purchase price than dollar cost averaging. Value averaging strategy follows the rule of making the investment value go up by a fixed amount. For example, let’s take it as $100 every month.
In January 2020, you owned $0 of stock, so you buy $100 worth of stock (at $4.64) to get 21.55 shares worth $100. Next month, February 2020, you need to increase your holdings by another $100 (from $100 to $200), so you must own a total of $200 of stock after February purchase. Because the new price is $4.38, you own 45.66 shares at $4.38 to make the value $200. When the share price goes down, you will spend more to top up the lost value. When the share price goes up, you spend less than $100 because capital gains have provided the excess in value.
When there is a large price increase, you will sell the stock instead of purchase. For example, after July 2020, your $700 worth of stock increases to $842.81 in August, you sell $42.81 worth of stock to reach your $800 goal. You trim your portfolio and rebalance it to cash.
The occasion selling indicated by value averaging rules is one of the most interesting strategies, this forces you to avoid big moves into peak market or panic selling at the bottom. This strategy will have its own issue if the market is in a constant bull run. It is best to use value averaging with index funds.
Adjusting for Growth
Adjust value averaging portfolio after 10 months of fixed value increases, if the inflation is one-half percent per month, we will adjust next month’s value goal for inflation. Remember earlier we use $100 per month, after 10 months will have $1000 value. We cater to inflation from $1000 to $1005. The $100 value increment we started out will be adjusted for inflation to $100.50. The next month’s value goal will be $1,105.50 instead of $1,100. Other than inflation, we need to adjust to growth equalization as what we have done for DCA.
Investment formula just keeps up with growth in the market over a very long term period and inflation-adjusted to keep up with inflation.
JC Fund Application
Assume we look at the existing fund in HKD, we will start to invest HKD 5,000/month from May 2020. We will adjust to inflation and growth to invest USD 5,200/month from January 2021 onwards with an increment of USD 200/month in FY2022 and USD 300/month in FY2023. I will split my take-home savings into half, buying into ES3.SI ETF and VT. Hopefully, I can continue this till March FY2022, the two index fund portfolios should create additional dividend income of SGD 4k/annum and USD 1k/annum.