Stocks & Strategy II

Pay Attention to the Average

When chatting with friends about my job, they often compare the stock market with a casino.

Well, I could argue with many facts contradicting this view, but I generally do not try to persuade people to invest. I only advise them if they want to play the markets.

And there is one point, where the stock market and the casino have in fact a striking similarity. People must be highly successful in both domains, since I hear many stories of winnings at the casino tables or, as a buddy recently told me: ‘The holidays in Dubai this year, I financed with my gains in stock xy.’

Well, if you belong to this category, congratulations. You surely need no advise how to invest.

In fact, you should advise me, because I had to swallow more than a few losses during my market adventures and had to accept, that you simply can’t avoid to stay on the wrong side of a trade now and then.

But you can use strategies to minimize your losses.

Scenario A: You invest 100’000 USD in a stock that gains 30%

Scenario B: Same amount, same stock, but you loose 30%.

Now you may think that the joy of an investor in scenario A is about the same as the pain from scenario B.

Well, that isn’t the case. We people have a clear loss aversion and strongly prefer avoiding losses to acquiring gains. Studies suggest that losses are twice as powerful, psychologically, as gains.

You are sceptic?

Imagine, you are a football expert and you win 500 RON with a correct bet. To celebrate, you invite a friend for a beer in a bar, where you get stolen 200 RON by a pocket-thief expert while celebrating. I bet, this loss clearly overshadows the earlier gain, isn’t it?

So back to markets. I’d like to present a strategy to reduce your losses: The DCA or Dollar-Cost-Averaging.

To show the effect of DCA, we return to scenario B.

Investors Razvan & Bogdan each have 100000 USD and want to invest in the same stock, currently traded at 100 USD a share.

Razvan invests the entire 100000 USD at once at the beginning of the year and purchases 1000 shares. Unfortunately, the stock price sinks regularly over the course of the year to 90, 80 and finally 70 USD. At the end of the year, Razvan has a loss of 30% or 30000 USD to accept. The shares he purchased for 100000 USD are now valued 70000 USD.

Bogdan used DCA. He bought the same stock but for a fixed amount of 25000 USD on a regular schedule at the beginning of each quarter, regardless of the share price. With DCA you automatically buy more shares, when prices are low, and fewer shares when prices are high.

His record at the end of the year looks like this.

share prices

Bogdan’s shares are almost 13811 USD higher valued than Razvan’s. Thanks to DCA, he holds close to 200 shares more in his portfolio.

Make no mistake, with DCA you cannot avoid losses completely, when shares are down, but it’s quite a difference between the 30% of Razvan and Bogdan’s 16% when we consider the strong loss aversion of humans.

Our two friends have enough from the markets and wouldn’t touch the portfolio for the coming year. Instead they travel the world. Upon return they check the market again.

E voila, the stock is back at 100 USD s share. Razvan’s portfolio is valued 100000 USD again and he is happy with the break-even. Then he finds out, that the portfolio of Bogdan is now valued almost 120000 USD, because he owns – thanks to DCA – 200 shares mote with the same amount invested. Razvan started to consider DCA a pretty clever stock-strategy.

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Have you ever heard of compound interest? If not, it’s time to know about, because this is your worst enemy, when you’re in debt – and your best friend, when you invest. Find out why in the next chapter: http://www.theleader.ro/best-friend-worst-enemy/

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