• What is going on in the markets?
• Long term investing is the way to go
• The average investor keeps on missing the big bull markets
• Investing during corrections: Dollar Cost Averaging (DCA) and Value Averaging (VA)

The markets are correcting, and whatever anyone tells you, no one knows if this correction will evolve into a full size crash as the one we are seeing in China. I believe that seeing European, U.S., or even other international Equity markets experiencing the same type of crash that we are seeing in China is quite complicated. Why? Because the bubble in China is quite uncommon and not comparable with the situation of other equity markets (check our post The Chinese Bubble Explained). However, the amount of uncertainty is quite high at this point.

The aggressive QE employed by different central banks, such as the BOJ, FED, and this year the ECB, has fueled great bull runs for the equity markets. Many analysts say that in the U.S. the stock prices are running out of touch with valuations. When you have this situation paired with:

• Unrest due to the Shanghai Stock Exchange crash,
• Yuan’s devaluation (you know about it from the last series Yuan Devaluation: Currency Wars revisited),
• Geopolitical tensions in numerous parts of the globe,
• Imminent rate hike by the FED, and the uncertainty about it,
• Some major economies already suffering recessions – Russia, Canada, Brazil (Japan might also enter soon),
• The crash in commodity prices

…you ought to be worry!

I am not trying to say that we are going to suffer a global recession and that the stock markets are all going to drop 40%, I just don’t know. However, the possibility is there, if fear starts taking the best of Investors we could see a major stock crash.

Can you believe that there are some investors that are still buying in this period? I know, it sounds quite crazy, but what about if I tell you that they are doing the right thing? No, I have not gone bananas, however, for those people that have an appropriate passive portfolio, the time to buy is always, and despite of the situation they should always be buying.

Let me explain why!

The market rewards long term investors

We all know that a Dollar, or euro, yuan, yen, pound, for that matter, invested in a major equity market around the world would always be more than one dollar if the time is allowed to make its work. In the U.S. there is no period longer than 15 years in the last 100 where 1 dollar invested was not worth more at the end than at the beggining, and in the English equity market only the WW periods were capable to cut the value of equity indexes for longer than 20 years, 24 years took those Brits that put money in the stock markets in 1900 to recover it.

However, the UK and the U.S. might not be the normal in the long-term returns spectrum.

You can read in the article from thisismoney, Credit Suisse Stock Market Returns 1900: The 24 year spell UK shares failed, that those investing in Italian stocks in 1905 or 1906 would have to wait over 70 years to recover their money, while those investing in German stocks in 1900 experienced negative returns even 50 years after their Investment.

It is scary to think that one could find himself in a situation in which he has to wait 60 years to make his money back… This might discourage a lot of people to become equity investors. However, it is important to understand that nowadays is quite easy to access almost any market in the world, and that a person in Italy can have a diversified portfolio with holdings in Japan, China, India, Germany, France, Chile, and the U.S., without that much of a hassle.

The following table shows the equity returns of some of the largest equity markets in the world since the beginning of the XX century and up to 2014. This table comes from Monevator, a great site for those interested in investment information in the UK in particular, and in the whole world in general.

As you can see every country has a positive annualized return since 1900, well, all of them but China. However, China’s numbers are from the start of the 90s and not from 1900. The cumulative return is what 1 dollar invested in 1900 would have become in 2014. As you can see there are major differences between countries. If you were Austrian and you invested a dollar worth of Krones in the market, 114 years later you would have the sizeable amount of… 2.1 dollars in Euros. Great job buddy! You cannot even buy a pint of Stiegl in the streets of Vienna… However, if you invested 1 dollar worth of Australian pounds (yes, in those times Australia had pounds!) you would get 3,332 dollars in Australian dollars in 2014 (not pounds anymore, amigo!), so you could get your “Aussie behind” on a trip around the globe and have as many Sitegls as you want in the streets of Vienna. All of this counting that you were able to live more than 114 years, which is a pretty common… right?

I think that these graphs and information teach us the importance of diversifying between regions and of investing for the long term, a lesson that seems we, retail investors, cannot learn.

The average investor still doesn’t listen to the data!

Let’s put the example of the U.S. Barry Riholtz gives some illustrative fact in his blog “The Big Picture.” The market (he is talking about the U.S. equity market), since 1974, has returned 11% per year in average, while the Average Investor has seen his assets increase at a rate of just 3%.

The following charts clearly show how American independent investors are not among those that benefited from the equity rally that we have seen since 2008.

There is enough data around that shows how the average investors get influenced by fear and greed. It is this fear what makes them get out of the markets (or not get in) right when bull trends are developing, and is this greed what makes them join the markets (or overinvest) when the bubbles are about to burst.

Since timing the market is such a tricky game, and cannot be done by average investors, there has to be a way for the average investor to stop this self-destructing behavior.

Of course there is!

How can we fix it? From dollar cost averaging to value averaging!

Let us start by Dollar Cost averaging

Dollar Cost Averaging

Also known as pound cost averaging in the U.K., dollar cost averaging (DCA), is a well-known investment strategy that tries to reduce the impact of short-term volatility on a particular investment by spreading the investment in equal amounts during a determined period.

It works as follows:

If you have $120,000 to invest in the equity markets, instead of investing the $120,000 tomorrow you spread the $120,000 in a determined number of weeks or months. In order to be able to perform dollar cost averaging we need a few parameters:

• The amount of money that we can invest
• The spread of time in which we want to divide the investment
• The periodicity of the investment

So, for example, if you want to invest your $120,000 in 12 months and you want to invest every 2 months, you know that through the next year you are going to make 6 investments of $20,000 every two months. These numbers could vary in order to fit the different investors preferences and needs.

There is a wide variety of research in DCA. In the 1990s there were many papers indicating the lack of validity of DCA (if you want to take a look: Knight and Mandell(1992/1993), Williams and Bacon(1993), Rozeff(1994), Thorley(1994), and Milevsky and Posner(1999)). These papers tried to show quantitatively how DCA portfolios were inferior to, for example, just investing your lump sum of money (the total amount that you can invest) on a particular moment. However, a variety of papers appeared since the year 2000 in support of this strategy or enhanced forms of this strategy (again, if you want to take a look: R Dubil (2005), LM Dunham, GC Friesen (2011)). However, the literature is still divided in this matter.

From my point of view, I think that DCA is a great way of bringing discipline to the average investor, and stopping him from buying expensive and selling cheap.

Note – Behavioral Finance is a quite new field in finance studies. This field tells us that investors are not “wealth maximizers,” as conventional financial theory used to illustrate, but that they act influenced by their emotions, and that psychology plays a huge role in the investment process. Investors tend to be, in the most part, irrational and unpredictable. The more this field is studied, the more advocates passive investment strategies are gaining.

DCA is one of these investment strategies, but I think there is an even better one…

Value Averaging

In 1988 Michael E Edleson published an article titled Value Averaging: A new approach to accumulation, and in 1991 a book named Value Averaging: The Safe and Easy Investment Strategy. In these two publications Edleson proposed a new way of building a portfolio, similar to DCA, but significantly different.

In order to build a portfolio using value averaging (VA), the investor needs to set a particular worth for the portfolio for each future period. The important part is that this future worth needs to be a function of the size of the initial investment. Here a clear example.

If you have the same $100,000 but you want to spread the investment through time in order to diminish the risk of buying on a top, you can set an initial investment of $50,000 and then set a revaluation every quarter for a 10% return. What this means is that after the first quarter your portfolio should have a value of $55,000.  If after 3 months your portfolio has a value of $45,000 you would need to buy $10,000 in order to meet the 10% criteria. Why? Because by definition you should have $55,000 due to the parameters that you specified, and you only have 45,000. In the case that the portfolio went up 10% you would not have to perform any action, and in the case that the portfolio went up more than 10% you would have to sell the excess amount.

You can see how in periods of strong returns the investor would add less to the portfolio, or even sell, and in periods of market declines the investor would have to add way more to the portfolio in order to keep the target return. Exactly the opposite of what the average investor does.

I wasn’t crazy when I said that many investors are buying in this type of market, and many more should be! The average investor cannot strive to be a market timer, since it has other priorities in mind, and becoming one requires full dedication. This is why we need to find ways in order to stop ourselves from trying to actively manage our portfolios when, if properly diversified and passively managed, they should give positive returns in the long run, specially after being risk-adjusted.

Up to here with today’s post. I hope you enjoyed the read, and the change! After three weeks of Currency Wars! If you haven’t read that series here the first post – Yuan Devaluation: Currency Wars Revisited. As always, make sure to ask anything that you want and/or contact us if you have anything to tell us. Have a nice weekend!

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