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Learning to play the stock averages

Investors have a variety of strategies to choose from given the advice that is readily available from financial gurus, advisers and the media.

Selecting one, or a combination, depends very much on the investor’s objectives, risk tolerance, circumstances and experience.

Conventional wisdom dictates that it is not possible to successfully time the direction of the market over a long period of time.

Market timing is a strategy of buying and selling by attempting to predict future market direction, typically through technical analysis and economic data.

Conversely, “buy and hold” is a long-term investment strategy where an investor buys stock and holds the position for a long period of time, despite periods of volatility or decline.

Dollar cost averaging (DCA) is a buy-and-hold strategy that also employs the market-timing technique of active trading.

The investor decides on a fixed amount of money that will be invested at fixed intervals, for instance weekly, monthly or quarterly.

For the strategy to be properly executed, the investor must have the capacity and commitment to make the investments methodically at the designated periods. An appropriate investment is chosen by the investor, usually mutual funds or exchange-traded funds, with an investment horizon of five to 10 years.

DCA is an alternative to investing on a lump sum basis. In investing a large amount at one time, there is the risk of making the investment at a high price. DCA minimises this risk as small purchases are made over long periods, avoiding extreme highs.

The rationale behind DCA is that fewer shares are purchased when prices are high and more are purchased when prices are low.

DCA removes the emotion from decision-making, temptation to time the market, and relieves investors from the burden of closely watching markets.

While once considered a popular and effective means of investing, DCA has come under considerable scrutiny.

Professor George Constantinides stated that “replacing one major gamble on a temporary shift of prices by a number of smaller gambles,” doesn’t necessarily work.  

Dollar value averaging (DVA) is a technique developed by former Harvard University professor Michael Edleson.

As with DCA, there is a fixed period where contributions are to be made, however, the investor sets an investment goal for each interval and also incorporates an expected rate of return.

For example the investor sets a target of increasing the value of his portfolio by $1,000 per quarter and a quarterly rate of return of 2 per cent.  

The first purchase is made for $1,000 at 10 per unit, resulting in 100 units. At the next scheduled quarterly interval, the price is $15, with a market value of $1,500.

The investor’s goal would be $2,020, the additional $1,000 quarterly contribution and $20 representing the 2 per cent return.

The top-up would be $520 to the existing value of $1,500 to achieve this.

With DVA the investor acquires more shares when prices fall and fewer when prices rise.

In certain circumstances, such as sharp gains in the investment, DVA may require that some units are sold to meet the target for the period. Both DCA and DVA are buy-and-hold strategies. However, the more active approach of DVA has proved in recent studies to generate superior returns.

Anthony Galliano is chief executive of Cambodian Investment Management.
anthonygalliano@covenantim.com

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