Over the past few weeks we have not been surprised to often hear friends and associates comment how they wished they had caught the bottom of the equity market. After all, with many of the major stock indices up forty something percent since March, wouldn’t we all like a piece of that? It’s the usual “shoulda, woulda, coulda” or the fish that got away story. That’s human nature after all. It will no doubt always be that way.
An investment strategy based on human emotions is one that is doomed to failure. Despite the complexities of international economics and financial markets there still remains a set of fundamental investment principles which take this emotion out of successful long term investing. Dollar cost averaging is one of the first covered in 101 books on investing and certainly over the past twelve months would have been a correct strategy. Dollar cost averaging is a timing strategy of investing equal dollar amounts regularly and periodically over specific time periods in a particular investment or portfolio. By doing so, more shares are purchased when prices are low and fewer shares are purchased when prices are high. The point of this is to lower the total average cost per share of the investment, giving the investor a lower overall cost for the shares purchased over time.
The part of the explanation of dollar cost averaging to focus on is the phrase “more shares are purchased when prices are low”. Volatility is your friend with this type of strategy. The last thing you want to do is to stop your disciplined buying when prices are low and only buy when they are high!
If you had $12,000 to invest a year ago, and you invested it all in an S&P 500 exchange traded fund on 31 August 2008, your investment would now be worth $9,229 (Blue Line). If you invested $1,000 each month-end from August last year in this same exchange traded fund, you would have invested a total of $12,000, but it would now be worth $12,885 (Red Line). Your average cost per share using the first strategy would have been $128.94 per share, while the average cost using the Dollar cost average strategy would have been $94.37 per share.
This leads us to illustrate the danger of taking an “investment holiday” when following such strategies. This indeed sounds similar and is topical to the conversation in the Cayman Islands at the moment concerning the discussions of a “pension holiday”. Dollar cost averaging is one of the primary and most important principles of long term pension investing. Think very hard and very carefully before considering if you should suspend your pension investment dollars at exactly the time when assets are under economic stress. Of course every individual has different circumstances and cash flow requirements. In the toughest of cases that might be the difference of keeping the lights on and food on your families table or, should you get the choice, continuing to pay your monthly pension contribution. However, before making that decision, we urge you to talk to a financial advisor and also to consider other ways to tighten your budget before leaving your pension behind and taking a “pension holiday”.
Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.