Wednesday, October 1, 2008

Emotions in investing

The current volatile market has a lot of investors running scared, particularly those who are going to be needing their retirement investments soon. This article is not for those people, but for those who have the luxury of time, that being 10 years or more, before they will have to access their funds.

Right now a lot of investors are selling all their stock holdings and buying cash and bonds, "safe" investments. But let's look at a previous downturn in the stock market and see what would happen if you did the opposite: when times get rough, load up on cheap stocks and watch them climb.

As a disclaimer, I'm no expert in financial advice, I only read a lot on the subject. But if you look at the data, buying high and selling low is a surefire way to lose money. If you continue to make your regular contributions to your retirement portfolio, rebalancing your asset allocation slightly if it helps you sleep at night, you will benefit from something called dollar-cost averaging. That is if you bought 1000 shares of a stock once when it was $10 and it rose to $12 a year later, you would have made $2000. However, if you bought 500 shares once when it was $10, 500 more 6 months later when it had plummeted to $5, and then watched it rise again to $12 you would have made $4500. So even though you bought during a rough period, you benefitted. Basically if you continuously contribute to your RRSP, sometimes you'll buy high, sometimes low, but overtime you'll average out in the middle.

So let us say you bought $10000 worth of the S&P/TSX 60 Index in Mar 2001. (This index basically buys stocks in the 60 top companies in Canada by market capitalization [number of shares X cost per share]). It was selling for roughly $10 a share so you would have purchased roughly 1000 shares. September 11 rolls along and a year later it is sitting somewhere in the realm of $8 a share. You panic and sell all your shares. Congratulations, you just lost $2000.

If you did not panic and simply let your investment sit, you would be sitting with 1000 shares worth $17.97 each, a tidy gain of $7970, or a percentage increase of 79.7%. Pretty nice.

Consider the alternative. You buy $5000 worth in Mar 2001, giving you 500 shares. When it dips to its lowest point, you double your investment and buy $5000 more, giving you 625 more shares. So now, present day, you have 1125 shares at $17.97 each, for a total of $20216.25, a gain of $10 216.25, $2246.25 more than if you bought it all at the start, and a total gain of 102%! So you see, a little risk taking pays off.

Think of it this way. You normally go through 1kg of coffee every 2 weeks, so if you buy extra it's not like it will go bad on you. You regularly pay $7 for one can. Along comes a sale at your favorite local store and it is selling for $4.96. What do you do? Well, the way the economy is headed, I'd take my current can to my neighbor, sell it to him for $4.96, even though I paid $7 for it, and suffer through the epic caffeine withdrawal, waiting for it to crawl back up to $7 so I can buy another can.

Come again?

If you were a raving caffeine addict like me you'd go out and buy two cans, because you know darn well next week it will be on for $7 again. And considering you would have to purchase the coffee soon anyway, you just saved yourself $4.08.

Now of course, if I don't purchase that coffee it's not like my next 30 years of retirement are ruined, so of course the analogy is not perfect. But like I've said, if you've got time on your hands, turn the contrarian side of your cerebrum on and start loading up on the cheap stuff.

No comments: