In his book entitled Common Sense in Mutual Funds, John Bogle said “Excessive confidence in smooth seas can blind us to the risk of storms”.  Indeed, the bull run of the Philippine Stock Market that started in 2003 and lasted up to the middle of 2007 gave so much confidence to a lot of investors that many are still hanging on to positions that they bought at the historical highs of the PSEi and other investment vehicles. The question now for most of these investors is whether to cut their losses now or just wait for the market to turn around.  On the other hand, if the “cost averaging” approach can work so well during volatile market conditions as many investors contend, can it also work for investors that are already invested and currently losing?  Or is cost averaging simply for fresh funds getting into the markets for the first time?

What is Peso Cost Averaging (PCA)?

Peso-cost averaging (referred to as dollar cost averaging in the US and pound cost averaging in the UK for obvious reasons) is done by simply investing a fixed peso amount into your mutual fund (or other investment instrument) at pre-determined intervals (normally less than a year – monthly, quarterly, etc) . The amount of money invested at each interval remains the same over time, but the number of shares purchased varies based on the market value of the shares at the time of a purchase. When the markets are up, you buy fewer shares per peso invested due to the higher cost per share. When the markets are down, the situation is reversed and you purchase a greater of number of shares per peso invested. It’s a strategic way to invest because you buy more shares when the cost is low, so you get an average cost per share over time, meaning you don’t have to invest the time and effort to monitor market movements and strategically time your investments.  While the effectiveness of the concept has been debated on for decades now, even the skeptics agree that the PCA does really reduce risk and avoid the possibility of “investing all the money at a market high”.

To illustrate PCA let us consider three market scenarios and two investing styles per scenario.  The first investing style is the typical lump sum investing where you invest all your money on one price and wait for the price to go up.  The other style of course is PCA.  To simplify our calculations let us say that we have P1,200 to invest over a one year period. 

 In our first market scenario the price of the mutual fund moved from P10/share to P5/share and then to 20/share (over the one year period).  In lump sum investing, our P1,200 can purchase 120 shares at P10/sharein January.  Hence, at the price of P20/share in December, the 120 shares that we bought has a total value of P2,400.00. By applying PCA where we invest P100 at the start of each month (for 12 months) we can purchase 136 shares (16 more than the lump sum strategy).  This is similar to a lump sum investment of P1,200 at a lower weighted average price (P8.80/share). This means that the value of our investment in December at P20/share is P2,720.00.

To be continued …