By imoney . 24 April 2015
The stock market is a tricky beast. You never know when it’s going to go up, down, or sideways. Even the most seasoned of stock market analysts can only predict so much. This volatility in stocks scares a lot of people off from investing, because they don’t have the time to spend analyzing companies and stocks and market movements with the scrutiny required to make the most informed investing decisions. And it’s just plain scary.
But what if there was a way for you to invest in the stock market at amounts you can afford and a schedule that works for you, all while providing lower risk? Even if there are no guarantees with the stock market, you can mitigate the risks by taking the easy, beginner-friendly way to investing: peso-cost averaging.
What is peso-cost averaging?
Simply put, peso cost averaging means you buy stocks or securities for a set amount of money each month or quarter over the medium- to long-term. This could be as low as P1,000 a month for three years, or as high P100,000 every quarter for five years. The amounts and time frames are up to your budget.
Because of the nature of the stock market, when you buy shares at a set limit, you’ll buy fewer shares when the prices are high and more shares when the prices are low. So if one month shares of Company X are at P5 each, you’ll get 200 shares for your P1,000. But if the next month the price goes up to P10, you’ll only get 100 shares for the same amount. You keep doing this for the amount of time you set, ideally at least five years. And then, when you feel that you’ve made a healthy profit from your investment, you can sell your shares and reap your reward.
Let’s say you decided to spend at most P5,000 a month on Universal Robina Corporation shares, a stock that Wall Street Journal analysts believe will outperform the market in 2015. And let’s say you do this for two years, starting two years ago (January 2, 2013). The following chart shows you how much you’ll spend in total for two years of peso-cost averaging, as well as the gains you’ll make:
*notes: historical values obtained from Yahoo! Finance and converted at the rate of 1 USD = 44.20 PHP, and may not directly correspond with the peso historical prices. Stocks are bought in multiples of 10 because of PSE board lot rules, which determine the minimum amount of stocks you can purchase. Stock prices are adjusted closing prices from the first trading day of the month. Costs like broker fees, transaction fees, and taxes are not included in this example for the purposes of clarity.
As you can see, by simply sticking to the peso-cost averaging system for a blue-chip stock like URC, you stand to gain over 60% of your investment after two years – and maybe even more if you stay invested longer in a good performer. Try to find a deposit account that can beat that.
Of course, nothing is for sure in the stock market, so keep an eye on the trend for your chosen stock, and have a contingency plan for when things go south. But if you choose blue-chip stocks, it’ll be much more likely, but not guaranteed, that you will come out with a healthy profit when you decide to sell after a few years.
What are the advantages of peso-cost averaging?
You can start with a small amount. A main deterrent to investment is the false belief that you need tens of thousands to even get started. But you can start peso-cost averaging at the manageable price of P5,000 a month. If you do that for a whole year, that’s P60,000 you invested in the stock market already!
You can invest at less cost and less risk. Because you’re spreading out your investment, you lessen the risk of “investing a large amount in a single investment at the wrong time,” according to Investopedia. For beginning investors who don’t have the time or expertise to carefully study stocks, peso-cost averaging is a good solution. Instead of focusing on timing the market, which requires a lot of effort, your focus is on accumulating assets. This method reduces your average share cost and spreads your investment risk over time. So your mistakes will be more controlled, less expensive and often offset by the good decisions you’ll make over time.
Even if the whole market is down at the end of the year, you can still come out ahead. Let’s say you had P100,000, and you decide to invest all of it at once in a stock priced at P100 a share in January. But by December, because of bad market conditions, the value of the stock went down to P90 a share. You thus lose 10% of your initial investment, and the market value of your shares is now down to P90,000.But what if instead of investing that P100,000 all in one go, you decided to peso-cost average and invest P25,000 per quarter? Take a look at this scenario:
Even as the year ended with the value of the stock going down by 10%, the market value of your shares is actually up by 4.58%. Not too shabby.
What are the disadvantages of peso-cost averaging?
You would have less profit than if you studied the market and performed analysis. This method won’t make you a lot of money very quickly since it’s focused on averaging out your losses (and thus your gains) over a long period. But since you’ll still need to buy and read the market you’ll be learning as you go along, preparing you for the real share trading fun!
You could pick the wrong stock and end up losing a lot of money. Cost-averaging by no means insulates you from loss entirely. If you keep using peso-cost averaging on a stock on its way down, and it never recovers, you’re still going to lose. But you can reduce the likelihood of this by investing in stable, dividend paying stocks like blue-chips. “Apply cost averaging on companies which have shown stable growth and performance over the past years to minimize your risks,” writes Fitz Villafuerte of the Ready to Be Rich blog in an email exchange with iMoney.
Studies show that lump sum investments outperform cost averaging 66% of the time. This is true, but if you get the timing wrong, market volatility will affect lump sum investments more. If the effect is particularly bad, you might get scared off by the losses and veer away from investing forever. Peso-cost averaging smoothes over the bumps of the market and gives you an investment plan that’s easy to stick to.
How do you do peso-cost averaging?
1. Figure out how much you can afford to invest. No matter if it’s P5,000 or P50,000 per month, you have to start somewhere. But to maximize the benefits of peso-cost averaging, you must be consistent with your investment amounts. As your income increases, you can increase your set amount as well.
2. Set a schedule for your investment. Will smaller monthly investments be more manageable for you, or would you prefer quarterly investments? Whatever you decide, make sure you can stick to it for years into the future.
3. Choose the right investment.
The best investment products for peso-cost averaging are blue-chip stocks and pooled funds. “Particularly, equity and growth funds perform very well if you do cost averaging on them for many years,” according to Villafuerte.
Do not use peso-cost averaging on a stock on its way down with no bright future ahead of it. If you do this, your losses will add up rapidly.
4. Remain committed to your investment schedule for at least 3 – 5 years. Peso-cost averaging works best in the long term. As long as you’re confident that the stock isn’t going down, don’t fret when you find that at one point in time you’re buying at a higher price than before. Remember, it’s a long term play. Stick to it.
So with a little bit of effort, and a lot of discipline, you can get started on investing right away with the peso-cost averaging method. All it takes is that first step!
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