Peso Cost Averaging: Does it work or not?

Peso Cost-Averaging: Does it work or not?

by: Kendrick Chua

You have just made your first purchase on stocks yesterday and excited as you are to check your portfolio, you discovered that the Dow Jones Industrial Average just dropped 777points last night-it’s single biggest decline in history. That itself won’t kill you but the local market following suit will.

True enough, your stocks just went on a downward spiral with no end in sight. Nervous as you are, you were prepared for this situation and thought of buying some more while it is getting “cheaper”. After all, didn’t the “experts” say that it is now time to buy? You rationalized this for a moment and remembered an article that Buffett is now buying. Your logic is telling you to take the plunge but your gut thinks otherwise. What do you do now?

The above scenario is very prevalent in the given economic condition. Just what exactly is cost averaging? Well, this strategy has been recommended (note: recommended) by brokers, fund managers and investment advisers when market is declining. From the term itself, it is buying a stock at a lower price than what you have previously bought making your average purchase price go down. Hence, the term cost-averaging.

In a simple illustration, if you have bought 10,000 shares at Ps 10.00 for each share, you would have invested Ps. 10,000.00. When the value goes down to Ps 5.00 each share (and assuming you haven’t sold yet), your investment would have decline to Ps. 5,000.00. If you employed cost-averaging strategy and decided to buy at this level, your break-even point would be at Ps. 7.50

Proponents of this strategy insist that this is how you can minimize your risk. There is wisdom to their position. By doing so, your break-even point becomes lower and when the stock price reaches back to Ps. 10; your second investment would have earned 25% already! Had you not done so, you would have miss out the gain or worse, may not have broken-even.

Cost-averaging are for those who see themselves as long-term and value investors. They believe that the intrinsic value of the stock is worth more than what it is being traded. Hence, the lower it goes, the better the bargain is and if before it was a “buy”, now it is a “screaming buy”!

However, this strategy has not been spared from criticisms. Opponents of this idea argue that while it may be logical to cost-average while the stock is going down, there is no way to accurately determine that you’d be able to buy at the bottom, unless of course you have a deck of tarot cards and crystal ball beside you and have consulted all astrological signs.

Cost-averaging does not minimize risk. It heightens the risk! If the stock price went from 10 to 5, what’s stopping it from going to 3 then 1? The idea is not far fetched as several issues in our PSEi have dropped more than 80% from their highs! So if the strategy was supposed to buy when the stock price drops, you would have just compounded a losing position, throwing away good money one after another.

Instead, they argue, wait until there is a clear sign of an upward trend before going in. Never mind the opportunity loss of buying at the bottom, at least your money didn’t suffer any losses.

So now, you’re in a dilemma: To buy or not to buy? Before you take the plunge, ask yourself several questions first:

1.)    Are you investing for the long term meaning holding the stock for more than ten years? Warren Buffett mentioned that the stock market is a voting machine in the short term and weighing machine in the long term and in time, the prices will reflect its true value.

2.)    Are you prepared to see your investment go lower even after you did the strategy? Let’s face it.  Nobody knows when a stock will hit rock-bottom. Some use the Price-Earning Ratio as the gauge. Others use the Relative Strength Index. In either case, they are not 100% accurate. Last 2008, all indicators were off the charts and despite all signs pointing to a rally, the stocks never did.

3.)    Are you buying a solid and reputable company? During the dot-com bubble, tech stocks were sky rocketing. And slight corrections signaled people to buy some more. Eventually, the bubble burst and these companies were nothing but a bunch of losers.

On the local front, a lot of investors profited handsomely from the mining sector rally in 2007. Mining issues kept hitting ceiling price everyday even if some of their projects never materialized. But when the market started to collapse, these stocks were hit harder than the rest.

On the other hand, even though blue-chip stocks were not sparred from the meltdown, they did fairly better than their counterparts and held their own against the losses.

If your answers are yes to all three, then chances are it is wise to proceed with this strategy. But only because you did a thorough research and self-examination, not because your broker or mutual fund representative told you it is so. Hey, how else are they going to earn if you don’t buy? In the end, a clear money management and some stroke of luck are what you just need in order to profit handsomely from this bear market.

Tags: investment strategy

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