Brent Sheather: Popular safe strategy comes at a cost

One of the strangest aspects of the investment business - up there with the belief that charting is a useful investment tool - is that no one seems to want to buy when things are cheap.

The stockmarket goes up, then sure enough the phone starts ringing.

This is unfortunate because, as we know from the research of Tim Bond at Barclays Capital in London, stockmarkets over the longer term "exhibit serial negative correlation", a fancy way of saying bad times are frequently followed by good.

Emerging markets investment legend Mark Mobius, of Templeton, gave a couple of seminars in New Zealand in the early 1990s and, towards the end of a meeting, one elderly gentleman asked: "When is it the right time to buy shares?"

Mobius wasn't fazed at all and simply said: "When you have got some money." Good practical advice because an automatic rule like that forces us to buy when we really don't want to - that is, frequently when things are cheap.

That sort of simple logic is also behind the popular investment tactic of dollar cost averaging. This is a strategy of, when faced with the task of investing a lump sum, spreading the investments over six or more regular purchases, thereby ensuring you don't buy at the top or at the bottom.

It is a kind of insurance policy and, given the common human trait of buying after things have gone up, it is probably insurance worth buying.

But, as we shall see, like all insurance, dollar cost averaging has a cost even though popular belief suggests otherwise.

The US-based Chartered Financial Analyst website published in August a note by two analysts from the New York office of Bernstein Global Wealth Management which looked at the costs and benefits of dollar cost averaging (DCA).

The proponents of DCA frequently cite the wisdom of "systematically investing a fixed amount of money at regular intervals". In this way, the story goes, one manages to get more shares of a stock when its price drops and fewer when prices rise.

This sounds plausible but it isn't the whole story. In the real world, prices go up far more often than they go down.

In fact, since 1926, in 76 per cent of every 12-month period, stock prices have risen so that a strategy which has you holding lower yielding cash instead of higher returning equities costs money.

Put simply, if markets are going up why hold cash? Better to buy immediately.

The Bernstein analysis calculates that the strategy costs about 4 per cent; the average gain of the stockmarket in all rolling 12-month periods since 1926 was 12 per cent.

During the same time, the average result of holding cash was 4 per cent. A strategy of DCA over a 12-month period came in at the middle - 8 per cent.

Regardless of how quickly one entered the stockmarket, the average one-year return was much better in years following a negative 12-month return than in years following a positive 12-month return. The strategy of investing all at once after a positive year generated average returns of 11 per cent but 15 per cent after a negative year.

The authors suggest that because behavioural finance tells us that our fear of financial loss exceeds our desire for gain; most of us prefer to enter the market in stages rather than all at once. Fine, if it makes you feel good, but let's be clear, the strategy doesn't make money, most of the time.

DCA has some other not so obvious drawbacks which only become apparent when you try to implement the strategy.

Many of the cheapest investment products in terms of annual management fees are listed on overseas stock exchanges but minimum brokerage fees in offshore markets can be excessive and can make DCA an expensive option unless you have serious money to invest.

Conversely, many locally based but expensive products do cater for DCA, particularly platforms operated by the larger financial planning firms.

If you are going to be a long-term investor, the lower management fees of non-DCA friendly products look much better value, particularly when one appreciates the real cost of DCA and is not seduced by the "buying more shares when they are cheap" fantasy.

Three other points are worth considering when assessing the attractiveness of DCA. Firstly, if you are one of those rare kinds of people who can act dispassionately and buy shares when things are gloomy, DCA is definitely not for you.

Secondly, the impact of DCA is mitigated by buying a balanced portfolio of bonds and shares - if one is buying shares at high prices one may well be buying bonds at low prices because the price of low-risk bonds tends to move in the opposite direction of shares.

Thirdly, if you happen to be dealing on the Australian Stock Exchange, there is every chance that DCA could make you go insane; if you have a family trust with say two or three trustees, there is about a 99 per cent probability that if you make six different purchases in one instrument the registry will spell one of the names differently each time, or maybe just omit the post code and you will end up with six different holdings and thus six annual reports, 12 dividend cheques per year, 12 tax statements etc.

Multiple that by three or four listed entities and the thrill of owning stocks soon wears off.

So to summarise: DCA is, for most of us, probably a good idea, but not because it means we automatically buy more stocks cheaply - markets go up more than they go down so, all things being equal, we should spend all of our money immediately.

The trouble is when we feel like buying, the market frequently has already gone up. DCA works because it overcomes our irrational predilection for buying high and forces us to invest systematically - provided we stick to the plan and don't alter our strategy when markets slide.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.