Buying Strategies I: Dollar / Pound Cost Averaging

As I mentioned in my last post, in an ideal investing world we’d always buy shares at the lowest possible price. When a share price drops for a Dividend Aristocrat, the yield increases because yield arrived at by dividing the annual dividend by the share price.

 

For example, with Standard Life (LSE: SL.), if you buy in at today’s price of about 203p per share and the trailing dividend – i.e. last year’s dividend – is 13p then your yield is (13p / 203p) X 100% = 6.40%. If the price of the share was 250p when you bought then the yield would be (13p / 250p) X 100% = 5.20%, while if the share price dropped to 175p then the yield would be (13p / 175p) X 100% = 7.43%. Consequently, assuming the dividend stays constant or increases over time, the lower the price you pay for the share the higher the yield and the better your return.

 

Many shares boast a high yield but whether the dividend will be maintained let alone increased over time is often in question. With Dividend Aristocrats, which have a history of 25+ years of paying and increasing the dividend year after year, the case is clear. The cheaper you buy the shares for your Child Millionaire Portfolio, the greater your initial yield, the greater your dividend payment because you will have more shares earning a dividend, and the more shares you’ll be able to purchase thorough automatic dividend reinvestment. As the number of shares your child owns increases with each quarterly or semi-annual dividend payment and reinvestment, the greater the future dividends and the greater your child’s future wealth as compounding over time does its work.

 

Now given that the direction of markets and share prices is unpredictable, how do we secure shares at a good price to ensure a high yield?

 

There are numerous methods investors employ. Some use fundamental analysis; some use the sometimes esoteric methods of ‘technical analysis’ or charting and some simply guess. I’ll get to some of these techniques in future posts. For now, though, I’d like to focus on ‘dollar or pound [or euro or yen] cost averaging,’ the most idiot-proof method for buying shares. Dollar / pound cost averaging is a widely known but often misunderstood and certainly poorly employed method for acquiring shares at a good price – not the lowest price but also not the highest – and best of all it can be fully automated.

 

The basic premise of dollar / pound cost averaging is that the method reduces your risk and uses volatility, of which markets have plenty these days, to get an overall lower average price for shares by buying more shares when the shares are cheap and buying fewer when the shares are expensive. I get into dollar / pound cost averaging in quite a bit of detail in Child Millionaire but here are the basics of how it works compared to buying at a single point in time.

 

Let’s assume you wanted to buy £1,200 worth of SL shares for your Child Millionaire Portfolio and we’ll compare three scenarios over the past six months from 9 May to 9 October 2011: scenario 1, buying all the shares on 9 May; scenario 2, buying by pure good luck, all of the shares at the absolute bottom of this period; and scenario three, dollar / pound cost averaging by making six equal investments of £200 starting on 9 May and then on the subsequent ninth of the following five months. We’ll then look at where we’d be today, 9 November 2011.

 

Assumptions: for simplicity we will use the closing price on each of these days as our notional purchase price and round down to the closest whole share. I’ll address dealing costs at the end.

 

Scenario 1, investing the full £1,200 on 9 May 2011 at the closing price of 218.20p per share: £1,200 / 218.20p per share = 549 shares purchased at 218.20p per share.

 

Scenario 2, investing the full £1,200 at the lowest point of the past six months (8 August 2011) at the closing price of 172p per share: £1,200 / 172p per share = 697 shares purchased at 172p per share.

 

Scenario 3

 

Dollar / pound cost averaging by purchasing £200 worth of shares on the 9th of each month [or the next open day for the markets] for a period of 6 months as follows:

 

9 May 2011 closing price: 218.50p

£200 / 218.50p = 91 shares purchased

 

9 June 2011 closing price: 206p

£200 / 206p = 97 shares

 

11 July 2011 closing price: 205.20p

£200 / 205.20p = 97 shares

 

9 August 2011 closing price: 174.10p

£200 / 174.10p = 114 shares

 

9 September 2011 closing price: 190.20p

£200 / 190.20p = 105 shares

 

10 October 2011 closing price: 210.50p

£200 / 210.50p = 95 shares

 

Total of 599 shares purchased at an average price of 200.75p per share

 

So how have we done in terms of yield and paper capital gains to 9 Nov 2011?

 

In scenario 1, using the trailing dividend of 13p per share, our share holding would be 549 shares and the yield would be (13p / 218.50p) X 100% = 5.95%. At today’s closing price of 202.6p the value of the holding would be £1,113.92 for a paper loss of £86.08

 

In scenario 2, using the trailing dividend of 13p per share, our share holding would be 697 shares and the yield would be (13p / 172p) X 100% = 7.56%. At today’s closing price of 202.6p the value of the holding would be £ 1,412.12 for a paper gain of £212.12.

 

In scenario 3, using the trailing dividend of 13p per share, our share holding would be 599 shares and the yield would be (13p / 200.75p average price) X 100% = 6.48%. At today’s closing price of 202.6p the value of the holding would be £1,213.57 for a paper gain of £13.57.

 

In all cases no dividend was paid because the 27 May semi-annual dividend payment was only paid to shareholders on record as of March 16, however in all three scenarios the next dividend payment on 18 November will be paid to all shareholders who were on record as of 17 August 2011. In scenario 1, the dividend will be paid on 549 shares, scenario 2 on 697 shares and scenario 3 on 599 shares.

 

So what can we conclude from these scenarios?

 

Clearly, buying at the bottom is the best strategy while buying at or near the top is a poor strategy. As I’ve mentioned before, this is blindingly obvious yet in practice it’s difficult if not impossible because the future is unclear and nobody knows which way a share price will go. The difficulty of making your full investment in one shot is that you could hit a high, a low or somewhere in between. You just don’t know and the difference between a poor price, a good price and an amazing price can be a matter of days. For example during the volatile summer of 2011, on 28 July SL closed at 200.90p, on 8 August it closed at 172p and 16 August it closed at 212.40p and had you bought on 27 October 2011, you’d have paid 224.40p, the highest price in six months. Over the entire 6 months, the price was only below 180p for three trading says so setting yourself up for scenario 2 would have required extraordinary insight and timing or dumb luck. You blink and you’ve missed it.

 

However, with scenario 3, the dollar / pound cost averaging approach of consistent regular buying regardless of what the share price does, you end up with a good overall price and yield without the risk of hitting a high or the impossibility and unlikely case of perfectly timing the low and actually buying while everyone else is panicking and selling. Best of all it can be set up automatically in your brokerage account so you don’t have to do anything or pay attention. This means that on 9 August when you automatically picked up £200 worth of shares for 174.10p you could have been sunning yourself of a beach rather than sweating over a keyboard as the markets plunged and investors panicked, wondering whether you should sell your holdings and run for the exits or buy more in the face of meltdown.

 

Dollar / pound cost averaging also applies to the reinvestment of dividends. When the dividend for SL is paid on 18 November, with an automatic reinvestment plan, you will effortlessly purchase shares to the value of the dividend at whatever price they are on that day, be it much higher or lower than today.

 

So what are the lessons?

 

Market timing is difficult if not impossible and requires watching share prices like a hawk and trying guess which way the market will move. This is a very active, probably obsessive, and definitely stressful investment approach and almost always fails to pick the highs and lows. The result is a strategy dictated by greed and fear rather than a cool methodical approach, with the most likely outcome that you will do exactly the wrong thing at the wrong time.

 

Dollar / pound cost averaging applies the Child Millionaire mantra of ‘strategic ignorance’. You set it up to happen automatically and then simply ignore the market and the short term direction of the share price and benefit from buying more shares when the price is low and fewer when the price is high while you get on with life.

 

What about the impact of dealing costs?

 

Using TD Waterhouse, UK as an example, you’d have paid £12.50 commission for a typical purchase in scenarios 1 and 2 along with Stamp Duty [not payable in many other countries] of 0.5% of the transaction value. With scenario 3, had you paid £12.50 per £200 transaction (£75 in total commissions plus Stamp Duty), this would be detrimental to your share holdings and future return. For small regular investments you want to avoid punitive dealing costs by making less frequent, perhaps quarterly, regular purchases or you may be able to find a brokerage account that offers a low-cost regular purchase facility. Brokers are able to do this by bundling orders and buying in bulk once a month on a predetermined day. TD Waterhouse UK has an account that does this for £1.50 per regular transaction so in scenario 3 the total dealing costs would be 6 X £1.50 = £9 for all six purchases. However, bizarrely and inexplicably [I know because I’ve asked them] this account does not allow automatic dividend reinvestment.

 

Different brokerages in different countries offer different prices for commissions, regular investments and dividend reinvestment so you will need to shop around for a broker that works best for your location and situation.

 

Set it up, automate it and relax.

 

 

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