Saturday, August 15, 2009

Dollar Cost Averaging – Practical Lessons From Recent Experience

My recent experience with Dollar Cost Averaging and the lessons I learned

Several posts ago I discussed my considerations on Dollar Cost Averaging and why I had selected it as my long term investment strategy.

I've been at it for 4 months and have shown the necessary self restraint, avoiding any impulse buying and selling and sticking to my original investment plan which includes investing a fixed, identical sum at the start of every month into a well diversified ETF portfolio.

It hasn't been as easy as it may seem. This is a good indication on my part. "Easy" usually doesn't lead to good results.

After short 4 months I've already learned several lessons I'd like to share in case some of you have decided to try Dollar Cost Averaging as well.

Lesson #1 - Speaking about self discipline and exercising it are two different matters

The idea is simple. Invest a fixed sum of money at each given period and average out sharp movements in asset prices. Drops in prices will be smoothed out by investments made during times of low prices (and the other way around as well, of course). Dollar Cost Averaging exposes an investor to less risk and therefore less return.

The challenge begins when we decide to implement Dollar Cost Averaging. When we save for retirement we usually take the money invested each period as a given and constant sum which we don't really have to think consider since this is a life term investment.

When investing our monthly savings things change. The level of commitment required from us is higher as we are in control of the funds invested. Suddenly we have to make the investment ourselves; committing to the asset of our choice and accepting the fact we are locking money for the long term.

Keeping to Dollar Cost Averaging when markets are peaking is challenging as well. Investing when you are sure the market faces a breather and a period of earning realizations is not an easy feat.

It is important to keep in mind our initial investment strategy and stray as little as possible. Remember why you adopted it at the first place. So far I've been able to keep to decision making but it was not as easy as I had though it to be.

Lesson #2 - Timing the markets is inherent in our psychology and is difficult to root out

I simply can't avoid timing the markets. Dollar Cost Averaging is probably one of the investment strategies which offer the most temptation to time the market as investments are made periodically.

Think of a scenario in which the market has rallied for 3 months (Like the past 3 months). Would invest, yet again, knowing full well the market is scheduled to take a breather? The same goes for bearish markets during which the temptation to buy more increases significantly.

Again self discipline is crucial for succeeding. Deciding to utilize Dollar Cost Averaging means abandoning the effort to time the market and recognizing them to be futile.

Lesson #3 - The long term is an obscure concept which is counter-intuitive to the human psychology

Again, my experience has taught me the long-term is one of the most obscure concepts in investing. Often mentioned but only rarely understood.

I believe long term investment actually contradicts human psychology and is very hard to maintain. When managing your own portfolio the urge to keep tabs is enormous. I haven't met anyone who can resist the temptation to monitor the portfolio daily or at best weekly or monthly.

In all sincerity, we may say long term but hope for short term. Again, self discipline and restraint are key traits for success.

In the meantime, and due to my rather lucky starting point I've managed to generate just over 10% in returns over the past 4 months which have been exceptionally well. I hope for a long term average of a yearly return of 6%.

Related Posts:

Friday, August 14, 2009

Making money online, Confirmation Bias and Lifestyle inflation @ Saturday Round Up

2 year recap and interesting reading from fellow bloggers

It has been a hectic year. My job takes up the best part of my life and between it and my 4 month old boy I have had little time to maintain The Personal Financier as I’d like.

I have been writing, here at The Personal Financier, for almost 2 years now and would like to think I’ve gathered a small crowd that enjoys my posts. I try to be innovative in my posting and avoid the shallowness which sometimes characterizes personal finance blogging.

I would like to believe my posts are useful and hold added value. I strive to walk off the beaten path as far as personal finance blogs are concerned. I would appreciate your comments and thoughts on the matter.

Interesting reading at fellow personal finance blogs:

Recent personal finance carnivals of interest:

Saturday, August 1, 2009

Buy on the Rumor – Sell on the News: Our Psychology at Work

A counter intuitive rule of thumb explained

Rumors of new products, earnings, takeovers and mergers immediately raise share prices. This is understandable as the value of the company is expected to rise as a result and so investors who believe the rumor to be true (or true enough) can buy on the rumor with the hope of generate significant returns in a short time.

Sell on the news is more intriguing. Usually this tested rule of thumb works. Many times after the news the share’s price shows signs of uncertainty and fear of the recent height it had attained. The reasons why can shed some light on how our psychologies play yet another trick on us.

Shouldn’t buying on the news be more appealing?

Solid investors should not buy on the rumor. Rumors have a tendency to turn out to be false and the share’s price soon follows to previous or lower levels. Still, buying on the news is more often than not too late for any short-term profit. Shouldn’t buying on the news be more appealing?

It seems rumors excite the imagination of investors so that by the time the news gets out it’s often disappointing by the mere fact it is grounded to a certain reality. I think something deeper, rooted in our psychology is at work, and I will expand on it shortly.

For the value investor buying on the news is the sound path for the long term. It is understandable how buying on the rumor may generate higher short-term returns as the associated risk is much higher since rumors may turn out to be false. Still, if you are not a speculator look for the hidden value in the news.

It is important to remember that many times the thought or idea of a certain takeover or merger is more exciting than the actual results. As we know everything is personal and merging two companies, two boards and two managements is hardly an easy task. An idea of a merger may be brilliant at first but if the operational and practical side is weak the merger is doomed.

Buy on the rumor sell on the news – the psychology at work

The more interesting aspect of buy on the rumor – sell on the news is the psychological aspect at play. This rule gives us another good example of how fragile our minds are and why the market is a place for the more rational.

Over and under corrections and the confidence bias – Think of the first think that comes to your mind when you hear a rumor regarding a company. We all believe the share prices will sky rocket and are sorry for missing the opportunity. A rumor of an opportunity has a very strong effect on us. Our psychology usually leads us to see the up side of such an event ignoring the limits and limitations that exist. Our optimistic view is quickly generated into a peak in the share’s price only to later face reality and correct the price back downwards to reflect reality and overshooting.

Expectations and reward pursuit – Strangely enough we seem to value some thing more when we wait for it to come true than we do when it finally does. This psychological bias has been demonstrated in research and is rather intuitive once you consider it.

When you plan a trip and consider all the wonderful activities you will enjoy your perceived utility is much higher than it actually is when participating in these activities. When expecting a raise, for example, its perceived value is higher than when you’ve already received it. The mechanism seems to be intuitive as well. Evolution has programmed us to constantly seek new rewards and never settle for what we already achieved.

Therefore, the perceived value of a certain rumor is more often higher than the actually value once it turns out to be true.

Psychology and investing go hand in hand. I find this connection fascinating and I’ve written quite a few posts about it exploring the different aspects and tricks our minds play on us. We can’t always control our psychologies but we can try to offset some of the bias and use it for our benefit.

Related posts:

Past week Round Up

The finance carnivals were, as usual, very productive. I'd like to note the following two:

Other great posts of the past week include the following: