Tuesday, October 14, 2008

Diversification, Costs and Dollar-Cost Averaging

This is the last instalment of my finance series.

So you want to invest in the stock market. The question is, what sort of stocks should you invest in? I've alluded to the issue of having to keep your investments locked for a fairly long period of time if you want to minimise the volatility of your investments. Unfortunately, companies come and companies go. Who even remembers Broderbund, or American Locomotive, or TSR, just to name a few? At times, even entire industries become defunct. Locomotives, steamships, ice-trawlers, all of these technologies have been surpassed by newer, better inventions. Yet, there was a time where these were considered safe investments.

So how do you know if a company is a good investment for the next couple of decades? You don't. You just need to diversify.

To use a simplistic example, when the price of oil goes up, oil companies do well, transport companies do badly. The reverse is true. Obviously, the solution is not to time your investments according to the price of oil (which is speculation and speculation is bad). The solution would be to invest in both, so that your investment becomes effectively immune to the volatile prices of oil.

Taken to the logical extreme, you would need to invest in a company of every type there is in the world in order to get true diversity. Is that even possible? Fortunately, there are shortcuts around this, and this is where I bring in index-investing and my rant a month ago.

An index is essentially a composite of the biggest movers and shakers in a certain stock market. The much-cited but often-misunderstood S&P 500 is an example. The short version - the S&P 500 is a composite of the stock prices of the 500 biggest companies in the United States, accounting for 80% of all the money that is raised through the NYSE and NASDAQ. It is safe to say that whatever happens to the S&P 500 index is indicative of the entire NYSE and NASDAQ, which is why it is usually cited as an quickie way of indicating a certain country's stock market performance. Other indices include the Nikkei (for Japan), the Hang Seng (for Hong Kong) and the STI (for Singapore). There exist funds out there that allow you to invest in these indices as a whole. The Vanguard S&P 500 is considered the god-king of all index funds, and if you have the means and ability to invest in this, this is definitely an option.

As you can see, index investing allows you to diversify quite simply. It does not offer true diversification, because each index usually covers only one country and certain factors can affect entire countries while leaving others intact, but it does make your job a lot simplier. My personal opinion is that economies are now so inter-connected that if you invest in a developed index, the general movements will be about the same. This graph tracking the S&P 500 and the STI sort of makes my point, though I note that the tracking is most true after 1996.

I've alluded to another investment vehicle in my earlier post - the iShares S&P 500 which is pretty much the same thing, though brokerage commissions makes this cost prohibitive for any single investment below 10k.

Which brings me to my next point of investing - cost.

************

Every "movement" in your investment incurs cost. Buying and selling shares involve brokerage commissions of 0.28% for discount brokerages in Singapore, or $25, whichever is less. Clearly, then, the cost of investment is prohibitive unless you can accumulate $10k to invest at a time.

Your other options are funds. Funds have their own problems. Usually, funds in Singapore allow you to put in small sums in every month, BUT, they charge you much larger ratios for this privelege. We're talking anywhere from 2 - 5 % upfront, and anywhere from 1 - 1.75% every year you keep the money in the fund. So yes, this is not an optimal solution either.

The cost of investment in Singapore is one of the reasons I wrote about my frustration over investing in Singapore all those months back. Your options are basically (i) invest in a fund, get ripped off (ii) invest in shares yourself, but only once everytime you accumulate 10k worth of cash or (iii) invest in a foreign fund, and get charged for overseas custodial fees (the fees the brokerage charges for keeping foreign shares on your behalf).

It would appear that (ii) is the best option, and in a lot of ways, it is. There is however, one catch to that.

************

My final point of investing is dollar-cost averaging. I spoke in my previous post about investing early and often. One reason is the "head-fake" I wrote about. The other is actually average out your costs of shares over the long term to overcome volatile stock prices.

Dollar-cost averaging is a simple concept. Every month you put aside some savings, say $1000. Every month, you sock this money away into a fund, or shares, whichever you prefer, and buy whatever amount of shares you can afford with this sum. This way, you average out the cost of shares over a long period of time, and you will get a roughly smooth progression of the price of shares without the volatility affecting it.

The issue with option (ii) above is that most people will take a long time to accumulate $10k. This tends to screw around with dollar cost averaging a little. The fewer times you invest, the more volatilty will affect you.

************

As with all things in life, there is no perfect solution. Each investment is a series of trade-offs you must make. However, if you reach the point where you can consider the trade-offs in your investment strategy, you're probably on the right track, and have avoided most of the major mistakes in investing.

Good luck, Pendragon. I've taught you as much as I can summarise in four posts. There's a lot more to learn, but the basics are mostly here. As with swordsmanship, there are things that definitely don't work, but even among the things that work, you have a choice. Take what you've learnt, make those choices, and turn this knowledge into your own.

4 comments:

Trebuchet said...

Well, I have a simple secret to share... HDB flat costs $200k or so, condo costs maybe 4-5 times more.

Take the difference and invest it. For a start, you have no mortgage; the amount you save per month can go into your dollar cost averaging fund.

This is for a simple middle-class guy like me. THose people out there with much more in assets will probably laugh.

*grin*

Khayce said...

Trebuchet,

Actually, I agree with you. Living in a HDB is probably one of the most cost effective ways of saving on housing expenses.

That is true whether you have a lot of assets or not.

Pendragon said...

Thank you for arming me with this knowledge. Now, let's see if I can make good use of it, so your efforts aren't wasted.

Eaststopper said...

Hi khayce,
Does the current crisis invoke any refinements to your advice on 'diversification'?

http://www.economist.com/finance/displaystory.cfm?story_id=12516688

Cheers,
Eaststopper