Deciphering The DCA-VCA Code
/“Grace is given of God, but knowledge is born in the market.”
Let’s face it; the human race simmers in discontent!
Most of us can benefit from attempts to lose weight, save consistently, control our temper, regain lost fitness, and invest more intelligently.
Although this is an article aimed at simply and methodically making you aware of useful investment strategies, I do realise that you have other concerns in life, as well. That’s why my e-book, 5 Steps to a Saner Life is designed to provide quick, multi-dimensional help to people who hunger to get better in many areas.
If you like, you can buy your own copy of this great e-book by returning to the main page of http://www.rajendevadason.com, and scrolling down to the E-bookstore section.
Right now, in this comprehensive resource article, I want to explain to you two strategies for more intelligent investing. But before you can invest prudently, you should have a fair amount of money saved. At the very least, you should have the establishment of your emergency buffer fund well under way. (If you’re not sure what that is, or how to do that, you’re welcome to read RESOURCE ARTICLE 3 in these archives.)
In essence, if you want to save more, then having your bank transfer a portion – say, 10% or 20% – of your salary to a separate, not easily accessible, savings account the moment it hits your main account is a great way to put your savings programme on autopilot.
Assuming that bit of housekeeping is out of the way, then to invest intelligently, an arithmetic anomaly can be harnessed to help build huge wealth over a span of 10, 20, or more years.
This anomaly is rooted in the ‘margin of safety’ concept of investing.
Here’s what ‘margin of safety’ means:
That, usually, though not always, the lower the price of a security goes, the safer it is and the greater its value as a potential long-term investment.
Courageous, patient individuals can take advantage of this to help meet long-term financial planning goals. Two established strategies are based on the premise that value and cost are two different things.
Those two strategies are dollar-cost averaging and value-cost averaging, commonly referred to as DCA and VCA.
I use both strategies extensively when working on solutions to help my financial planning clients increase their likelihood of achieving key material goals such as enjoying an excellent retirement, funding their children’s tertiary education programmes, or attaining that tantalising target called financial freedom!
But because I use both strategies so often, I’ve grown blasé about their ability to deliver healthy compounding returns. So, to get back in touch with the needs of the general public, I recently polled readers of my electronic newsletter GET BETTER (which, by the way, you are welcome to subscribe to and to tell as many serious-minded friends about).
The question I asked was, “Which strategy – DCA or VCA – would you rather have me explain?”
The response was startling. With only one exception, everyone who responded eagerly wanted to learn more about both DCA and VCA strategies.
Hence, this piece!
BREAD AND BUTTER DCA
The best way I can think of to explain the mechanism behind a sound dollar-cost
averaging (DCA) programme is to begin by outlining the six criteria any
investment asset should meet before a DCA programme is embarked on:
1. The investor must exercise due diligence in ascertaining if the investment is
of sufficiently high quality to warrant parking money in it;
2. The value of the investment should fluctuate over time;
3. The investment time frame should be fairly long, typically at least 7 years;
4. Investments should be made at regular intervals, say once a month or once a
quarter or once a year;
5. Investments at each of those intervals should be made in equal dollar (or
sterling, euro, ringgit, yen, peso and so on) amounts; and
6. These regular investments should continue through all kinds of market
conditions – good, bad and indifferent.
Look at this table for a simple time-compressed illustration of equal mutual fund or unit trust fund investments.
Now, let’s say you have $120,000 to invest, and are raring to go!
You are faced with three choices:
A. You do nothing significant and keep your money in a certificate of deposit
(CD) or fixed deposit (FD) account earning, say, 4% for the year;
B. You invest the full sum into a mutual fund or unit trust fund today; and
C. You gradually invest $10,000 each month for 12 months into that fund.
In the intervening 12 months, the price of the investment fluctuates. For simplicity, the cost of entry is considered to be negligible. (In reality this is not the case, and should be a factor of consideration.)
In option A, $4,800 is earned as interest.
In option B, based on the completely fictional, but realistic, price fluctuations, $7,200 is earned in total returns of the lump-sum investment (based solely on the final price of 53 cents being 6% higher than the opening price of 50 cents).
In option C, the same amount is invested each month; this requires discipline. The amount is invested regardless of whether the market goes up or down; that requires courage (and faith).
When the price falls, more units are bought through the fixed monthly investment. When the price rises, fewer units are bought for that same fixed monthly investment amount.
Based solely on the numbers above, the arithmetic average price is 47.67 cents. The actual average cost is equal to $120,000/252,677.61 units = 47.49 cents. Even at this point, the advantage of averaging is obvious. But things get better!
In this example, the actual profit is almost double B’s because of the effectiveness of buying a lot of units when prices fall and fewer as prices rise. In this particular example, the absolute profit is $13,919.13 (before front end loads, but also without taking into consideration the bank interest earned by the unallocated portion of the $120,000 during the course of the year.)
Frankly, because you don’t always want to have to work for your daily bread, perhaps now’s the time to initiate a simple DCA strategy, based on those six criteria, to help you strip emotions from investing.
BUT BEWARE, EQUITY RETURNS ARE NEVER GUARANTEED!
INTERLUDE: GAINING AN INVALUABLE SENSE OF PERSPECTIVE
The need to strip emotions from investing is great and persistent. The reasons are fear and greed – The two key emotions at play in any equity market.
Fear rises within most retail investors when the market is low, and greed surfaces when the market jumps.
So, most find it easier to invest when the market is high than when it is low. While understandable, it’s the wrong thing to do!
An analogy I’ve used in conferences, seminars, in my free self-help electronic newsletter GET BETTER, and that I revisit in different forms with my elite fee-based financial planning clients is the thought experiment of identical twins, Adam and Ben.
If Adam stands on the floor and Ben stands four feet above him on a ladder, who is more stable?
Intuitively, most people will say Adam, which is correct. Basic science reveals the reason for Ben’s reduced stability is his higher centre of gravity or CG.
(That’s why racing cars have low profiles. The closer they hug the track, the lower their CG, and the more stable they are.)
>From the perspective of a long-term investor, not a short-term momentum trader, it’s riskier to invest when the market is constantly hitting new highs. It’s safer to invest when the market is in shambles and scraping the bottom.
As the Father of Security Analysis, Benjamin Graham, explained a long time ago to his investment class at New York’s Columbia University, generally speaking, the cheaper an investment (compared to other prices it has traded at in the past, not compared to other investments) the greater the margin of safety.
If you would like to learn more about Benjamin Graham, his most famous protégé Warren Buffett (the world’s greatest stock picker and right now the second richest man on Earth), as well as to embark upon a five-year self-study programme in personal finance, economics and investing, then my FREE e-book 26 Books to Take YOU All the Way to the TOP! is an ideal resource for you!
You may download this e-book at the main page of http://www.rajendevadason.com. Just scroll down to the E-bookstore section, click on its icon, and follow the download instructions.
Right, now that you understand the excellent investment strategy, DCA, let’s zoom in on the more sophisticated approach of value-cost averaging (VCA):
CAKE AND CREAM VCA
A well-implemented VCA strategy hinges upon Graham’s ‘margin of safety’ concept. Unfortunately, this approach only suits relatively well-heeled investors.
These are the seven criteria that must be met before a VCA programme can be considered:
1. The investor must have an iron constitution that permits him to invest more
money when the market is collapsing, and helps him exercise discipline in
investing less money when the market is rising. This is often counter-intuitive
and difficult for many retail investors.
2. The investor must exercise due diligence in ascertaining if his targeted
investment is of sufficiently high quality to warrant parking money in;
3. The value of the investment should fluctuate over time;
4. The investment time frame should be fairly long, at least 5 years;
5. Investments should be made at regular intervals;
6. Investments at each of those intervals should be made in UNEQUAL dollar (or
whatever your base currency may be) amounts governed by two parameters – the
amount already invested and the level of the market; and finally
7. These regular investments should continue through all kinds of market
conditions – good, bad and indifferent.
The principle is easy to comprehend; implementation is tricky.
Say, you choose to invest over a brief 3-month period (for illustration only, ideally, in my opinion, the minimum VCA period should be 60 months). In month 1, your investment’s price is $1, in month 2, it’s $1.20, and in month 3 $0.80.
To a person driven by unbridled emotion, it’s easier to fork out more money when the investment is flying from $1 to $1.20. But as the investment nosedives from $1.20 to 80 cents, fear sets in, resulting in reduced investing inclination or, worse, panicked selling.
A VCA programme helps neutralise such emotions. Here’s how:
Say you begin your programme with a $100 investment.
In month 1, the investment costs $1, so you buy 100 units with your $100 investment. A month later, the targeted VALUE of your next investment will be $100 x 2 = $200. Your targeted VALUE after that will be $100 x 3 = $300.
In month 2, the investment value rises to $1.20, so your 100 units will be valued at $120. You only need to top up another $80 to hit your target of $200. (The market has risen and you’ve invested LESS!) You only buy $80/$1.20 units, which is about 67 units.
In month 3, the investment falls to $0.80. Your existing 167 units drop in value from $200 to about $134 (= $0.80 x 167). Your targeted value is $300, so you now add another $166, to buy 207.5 units. (The market has fallen and you pump in much more money than before!)
The net effect over time is you buy plenty of cheap units and few expensive ones.
If the market never recovers, you may bankrupt yourself.
But if it does recover, which has always been the case up till now, you will
profit.
For a more rigorous example, study this simple time-compressed illustration of
unequal VCA-based mutual fund or unit trust fund investments.
Over a long period, the cumulative benefits of a VCA programme over a DCA one will snowball. The only downside is it is an absolute pain to administer!
Therefore, those eager to implement such a programme must ensure that your mutual fund or unit trust agent, or appropriately licensed financial planner understands the intricacies of a disciplined VCA approach, and is willing to do the extra work for you. A good place to start your search would be in the CFP directory of your home country.
(For instance, in the US, you can check out the website of the Financial Planning Association (FPA) at http://www.fpanet.org. In Malaysia, my home country, the appropriate website is that of the Financial Planning Association of Malaysia (FPAM) at www.fpam.org.my (you’ll even find a short message from me in the FPAM website’s CFP Directory!). A simple search on GOOGLE should help you zero in on the appropriate national administering body and the relevant CFP directory.)
In weighing the pros and cons of a DCA strategy and a VCA one, the biggest plus point of DCA is its ease of implementation. This simplicity should not be sneered at. My experience suggests that the simpler the strategy, the likelier people can stick to it over the long haul.
As for the most important benefit of the VCA, in my opinion, it is the potential for greater long-term compounded returns. But be warned: These come at the price of added work in terms of monitoring, calculating and implementing.
If you feel a bit intimidated by the contents in this article, I don’t blame you.
In fact, I might be able to help.
If you don’t know as much as you’d like to about the stock market, for instance, then my first book, Your A-Z Guide to the Stock Market – And all You Need to Know About Capital Terms, is a great resource. It contains 1,001 terms that are usefully cross-linked to help you take a self-directed journey of financial self-education. (If you would like to order a copy, do drop my associate Steven Poh an email at steven@i2media.com.my).
Whatever you decide to do in terms of future investment strategies, I wish you well.
Above all else – materially speaking, at least – I hope you will decide to
become a courageous lifetime investor.