Tuesday, April 27, 2010

Buying at the right price is my way of market timing.

When buying an investment, how do you know the price is right? This is the second toughest question for an investor, right after when to sell. So we have decided to buy into the stock market with the expectation of having a return between 6.5 and 7% plus inflation per year. That, according to Jeremy Siegel is the typical return on the stock market long term. But does that mean you are starting to buy right now?

Not necessarily. Here are a few things you want to check out:
1. Is the market trading near a 52-week high or a multi-year high?
2. Are we in an overall market up or down trend?
3. What is the average market dividend yield and how does it compare with short and 5 year interest rates?
4. What is the typical price to book value?
5. What is the P/E ratio on average and how does it compare with short and 5 year interest rates?

As long as the market seems to behave reasonable, i.e. there is no speculative frenzy with shares trading reasonably compared to interest rates (questions 1-5), it is fine to buy. Buy in such a market and hold for the long term, as discussed earlier, and you will do O.K.

If you do not understand the terms above, it would be advisable to study past postings on this blog and a number of books on stock market investing. A listing of books for beginning investors in the stock market goes beyond this post. However, if anything above does sound unfamiliar to you, do NOT invest in stocks until you know more.

As you may have noticed, we are not talking about individual stocks, buying such shares requires considerable knowledge of specific companies. Some people buy on tips from neighbours, friends or acquaintances, this often results in significant losses, so we don’t.

What about mutual funds? Many investment letters state that active managed stock portfolios such as mutual funds are a good way to invest in a diversified manner. But they also tell us that the management fees and commissions paid for those mutual funds are so high that the investment returns underperform the stock market.

For now, why not buy all stocks of the TSX300 instead? We could use an Exchange Traded Fund (ETF) which you can buy through your discount brokerage at a low commission and with minimal MER (Management expense ratio). OK we’re done! We buy it and let it sit for the next 200 years ‘et voila’ a greatly diversified investment portfolio has been created.

We could refine our strategy a bit. As discussed in earlier blogs, a significant proportion of profits is derived from dividends that are reinvested. Dividend paying companies are well established and because of their confidence in their future performance, they pay out part of their profits. Some of these company’s also buy back their own shares, something not yet discussed on this blog, but it often contributes to further profits for the investor. Personally, I prefer to invest in the largest company’s of the TSX, often called the TSX60 companies. Many pay dividends and are very well established. Currently, in my opinion, Canada is one of the best places in the world to invest, so let’s stick for now with Canadian stocks of the TSX60.

Rather than investing all our money at once, kind of gambling that today is the best day to buy; one can follow some specific buying strategies. One such strategy ensures that you don’t have to be too concerned about the buying price. It is called ‘Cost Averaging’ and consists of buying stocks in relatively small amounts at regular intervals, e.g. every month.

There are some considerations though! You may like to invest every month $50. However, you would have to pay the discount broker $9.99 commissions for each purchase. That is 25% commission; Ough! Answer: Join the Canadian Shareowners Association. They let you buy small amounts at one time for small commissions. Also they have a great dividend reinvestment program that allows small investors to buy with no commissions.

Or... you could invest once every two months then your commission is still $9.99 but now on $100 invested. This is still high (12.5%) but it is more reasonable. So, you get the concept: either save more or invest once every 6 months or so to get your commission rate down.

Say, you have every month $500 to invest.Then your commission of $9.99 represents just under 2%. Not cheap but as long as you don’t sell for a number of years it will become negligible. So say you invest $500 in January of year 1 in an ETF of the TSX60 which at that time trades at $19.00. You buy 500-9.99 divided by 19.00 = 25.79 shares. A month later you invest another $500 when the share price is $18.73 and after commission you buy another 26.16 shares. After three months you receive your first dividend, say $11.99 which you will reinvest in the fourth month together with your $500 contribution. At the then prevailing share price of $17.00 you buy another 29.53 shares. You keep on doing this for the next 5 years and although prices overall increase at 7% per year with an average dividend yield of 3%, prices are quite volatile varying by as much as 50%. .

So since you invest every month $500 or $500 plus dividend, you buy more shares when prices are low and less when prices are high. This technique, called 'cost averaging', allows you to invest without emotions, and you are purchase costs will average out over time. Based on my spreadsheet model and depending on the random market movements (with a 50% price volatility), your return on investment will range from 9.9% to 15.3 and typically be around 12%. If you did not re-invest the dividends but rather kept the cash, your return would be 0.4 to 0.7% lower. The graph below shows how the price movements may have been.

If the market price had been less volatile, say up or down 10% rather than 50%, your ROI would have been a lot less ranging from 5.4% to 5.9%. So with income averaging and investing every month $500 like clockwork in a volatile market (a high risk market as people may say) your return would have been easily double than when the stock market was nice and smooth and ‘predictable’. Even if your initial $500 purchase had been made at the peak of a bull market, you would have done fine – as long as you stuck with the plan and did not sell in a panic!

By investing $500 each month over a 5 year period, my average amount invested would have been $15,000 over 5 years. If I had invested that $15,000 at the absolute bottom of the market at once, my return would have been 28.6%. Which shows that the price at which you invest is important; but who can time that well?  Of course, you could have made several purchases spread out over the duration of a bear market instead.Your average purchase price would not have been as good as at the perfect bottom of the market, but chances are that you would have bought at a significant lower price than using the cost averaging method and your returns would probably have been well in the 20% per year range, which is something many real estate investors dream of.

So, market timing is a sure way to lose or under perform. Cost averaging in a volatile market will result in respectable ROIs. Buying at the perfect market bottom is impossible; but buying at a good price spread out over a significant portion of a bear market will result in achievable and very attractive results. That is what I mean when stating that you want to buy at the right price (not necessarily at the perfect price). Simple as this sounds, it takes a strong stomach to keep on buying in a bear market while seeing your net worth falling every day. But that is when you will make the best ROIs, provided you have cash.

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