Sunday, December 1, 2013

Bullshit financial theories part 1: Dollar-cost averaging

Disclaimer: I’m not advising anyone to follow my opinions in this article. It’s your money. Do whatever you think is best for you.

In this article, I will try to destroy the myth that’s dollar-cost averaging. I’m sure many of you have heard some mofo talk about how awesome dollar-cost averaging is. And while I think it’s alright to dollar-cost average a lot of the time, it’s pretty dumb to do it all the time regardless of the broader market’s valuation.

If the broader market has a reasonable average price-to-earnings (P/E) ratio of 17 or below, then there’s absolutely nothing wrong with dollar-cost averaging. But what if the broader market has an average P/E ratio of 25? I would feel a little uncomfortable investing then, but I guess over the long-term it should work out.

How about dollar-cost averaging when the broader market has an average P/E ratio of 35? I certainly don’t think it’s smart then as it would mean that the average earnings yield of the broader market is only 2.85%. You can invest in government bonds and earn more than 2.85% risk-free (risk-free is bullshit as well, but we’ll get into that another time). Investors that dollar-cost average regardless of valuation could be throwing a lot of good money after bad as the market can be irrational for a long-time. In the period of 1987-1991, the Nikkei 225 was over 20,000 (it even went up to over 35,000 for a while). Today, the Nikkei is at 15,661. Imagine the damage you would have done if you practiced dollar-cost averaging during that period. I couldn’t do more damage to my regular McDonald’s restaurant even if double cheeseburgers were free.

Look, the purpose of dollar-cost averaging is to reduce the average cost of your investment over the long-term. So, shouldn’t the best way to reduce the average cost of your investment be to simply not fucking invest when the market is blatantly overvalued.

Note: After a crash and during a recession, the market might still have a high average P/E ratio as companies could still be losing money or earning very low profits. This is where you have to calculate (or get someone to calculate) the average P/E ratio of the broader market based on profits in normal times to see if it makes sense to invest.

This is how I would invest my money if I didn’t know shit about investing:
1)      Invest in the broader market of a few solid countries through exchange traded funds or unit trusts. This way my exposure to country risk will be reduced.
2)      Make sure to select investment vehicles with low fees as fees could take a large chunk out of my profits over the long-term.
3)       I will invest regularly (perhaps once every month), but only if the national markets my exchange traded funds or unit trusts are tracking have average P/E ratios of below 20. I guess the threshold could be a bit higher, but I get uncomfortable once the average P/E ratio is above 25.
4)      If there are no opportunities to invest my money, I will just build up cash for when the markets get cheaper. I think I would start investing the cash I built up when the markets’ average P/E ratios drop below 15.


Thank you for reading. Take care and stay rational!

1 comment:

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