Although it’s not appropriate to use gambling as an analogy for investment, but I find that it is an efficient way of illustrating the concept of dollar cost averaging.
Supposely you are all “gung-ho” today and decided to drive up Genting (a casino in Malaysia) to try your luck. Let me give you a simple tip on how you can win Uncle Lim (nickname for the casino owner).
i) Let’s say you start by betting RM 5.00. You lost. Total lost RM 5.00.
ii) So you double your bet to RM10.00. You lost again. Total lost RM 15.00.
iii) This time you bet RM 15.00. Lost again. Total lost RM 30.00.
iv) You bet RM 40.00 this time. This time you won. Total winnings RM 10.00
This method guarantees that in the worst case scenario, say even if you continue to lose for the next 50 hands, you will still be able to win back your losses by betting the sum of your total loses from the previous bet, provided you have enough capital to fund the subsequent bets.
The keyword here is “provided”. If we are talking about small bets like the one above, most of us can do it. However, when it comes to thousands of ringgit in the investment market, the scenario might not be as simple as that.
Now, let’s apply the concept we just understood from the above scenario in the stock market cycle. Let’s take Fund A. Fund A invest in high growth stocks. Though we cannot guarantee when Fund A will hit its lowest or highest point (if we could, you should stop reading this now and give us a call right away). What we can guarantee is that Fund A, like all other types of investment vehicles, will experience fluctuations of ups and downs. So, by banking on this guarantee of fluctuations we do the following:-
i) We invest RM 1000 at the peak of the fluctuation where every unit is RM 1.00.
ii) 3 months later, the price per unit drop to RM0.50. We invest again with similar amount of the capital. Notice that we are now investing at an average RM 0.75 per unit.
iii) 3 months later the price went up to RM 0.90 per unit. In total, we’ve just made a RM 0.15 capital gain per unit.
So, the question would be, what would happen if we did not invest again when the price dropped to RM 0.50. We would not have been able to take advantage of it, and hence would not be able to see a positive return when the Fund shot back to RM 0.90.
Dollar cost averaging is investing through a periodical of time with either fixed or non-fixed amount. We can start buying more when the price is plunging or buy less when the fund gets bullish. However, we can only do this type dollar cost averaging if we had planned our investment beforehand. Instead of investing one lump sum of your available cash in hand, we should try to manage our cash and invest them in a few intervals.
From the mutual fund perspective, a mutual fund manager has, in her discretion, a large pool of “cash”, usually amounting to billions of ringgit. By applying the same concept, the fund manager can perform “dollar cost averaging” with higher efficiency and with better results than a single investors could have done with his entire cash savings.
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