If you have followed my previous 2 blog posts, you might be confused whether investing is easy. On one hand, I mentioned that there are ways to invest wisely. On the other hand, I also mentioned that investing is not a bed of roses. How should you make out of these 2 seemingly contradictory blog posts?
First and foremost, investing is really not easy. You know that the trick to making money is to buy low and sell high. You may also have a plan to ensure that you buy low and sell high. You also know that if you invest at the bottom of a bear market, you will make a lot of money. However, when that bear market happens, your existing portfolio will be showing a lot of losses. Assuming you have a portfolio of 20 stocks, easily 15 of them would be in the red, with a few of them so deeply in the red that it is virtually impossible for them to recover to their original prices. The sea of red can be very frightening. The more you try to save your portfolio by bargain hunting, the deeper in the red your portfolio becomes. You do not know for sure whether the market will sink deeper or when your war chest will be exhausted. When that happens, are you sure you still have the conviction to stick to your plan of buying low and selling high? The worse thing that can happen besides losing money is to lose your confidence. If a stock loses 50% of its value and you still have confidence in it, you would hang on to it. But if you do not have the confidence, even a 5% drop would prompt you to sell it off. Besides losses in the market, other things could happen at the same time, which will further weaken your confidence. La Papillion has written a wonderful blog post on what could happen during a severe market crisis such as the Global Financial Crisis. It is so good that you should read the original.
While active investment strategies are losing confidence, it is business as usual for passive investing strategies such as Dollar Cost Averaging (DCA) and portfolio rebalancing. With DCA, you invest a constant amount of money in the stocks or unit trusts on a regular basis regardless of whether the market is a raging bull market or a rampaging bear market. Every month, you drilled yourself in putting money into the stocks or unit trusts. This drill will continue during the months of a bear market. With portfolio rebalancing, you check whether the allocation to different asset classes have drifted far away from the intended allocation and rebalance the amount allocated if it does. Just like DCA, you drilled yourself to check the allocation every few months and rebalance when needed. Even though actual rebalancing only takes place occasionally, you will not hesitate to rebalance when the time calls for it, even during a bear market.
One crucial reason why it can be business as usual for passive investment strategies is they usually do not run out of "bullets" for investing. This means that they will outlast any bear market. With active investment strategies, no matter how huge your war chest is, it is actually finite because you do not know how fast you are going to deploy it nor how long the bear market will last. With DCA, the small but steady stream of investment cashflow is comparably more infinite if you have already bought adequate insurance and set aside sufficient funds for emergencies. With portfolio rebalancing, you do not need to add more cash to your portfolio. The war chest is the portion that you allocate to bonds and cash. While the war chest will keep on shrinking as you continue to rebalance out of it as the market drops, every remaining dollar in the war chest buys you more of the same stock or unit trust. You can keep on rebalancing until the bear market bottoms out. When you are still standing when the bear drops off, you are going to recoup all the losses lost to the bear market and make money when the bull market takes over.
To conclude, investing is not a bed of roses. But there are ways to invest wisely.
See related blog posts:
DCA is a great way to invest small amount of money. There is another method known as the Permanent Portfolio where you invest in equal portions of the account in different asset classes (bonds, stocks, gold, cash). But this method needs more work than a DCA.ReplyDelete
Hi Investing Wolf,Delete
Sorry for the late reply as I'm in the busy phase of my project. Yes, I quite like the concept of a Permanent Portfolio and the ideas behind it.
To me, investing is simple but never easy (if we are talking about consistent profit) ;-)ReplyDelete
Oh, talking about DCA, there is a new kid on the block for the automated regular investment plan, if you are interested, you can check out my coverage here http://www.investopenly.com/2015/03/regular-stock-investment-plans.html
Sorry for the late reply as I'm in the busy phase of my project. Thanks for the link. The comparison you've done is useful info for anyone interested in DCA.
Thanks for putting my links up there :) I think to further add in to the concept of DCA, it's wiser to use DCA on etf rather than on individual stocks. Use the survivorship bias of etf to your advantage to ensure that your hard earned money won't be going down the longkang!
Hi La Papillion,Delete
Sorry for the late reply as I'm in the busy phase of my project. You're right to say that it is very important that we select the correct instrument to invest so that we can reap the benefits of DCA when it recovers, else it would be throwing money down the drain.