Don't Practice Dollar Cost Averaging Blindly

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A unit trust consultant comes to see his client with a big smile when the stock market falls. He says the client is lucky now that the NAV [net asset value] of his unit trust investment has dropped. If he practice dollar-cost averaging, then he will bring down his cost significantly. So, he should grab this opportunity to add more investment.   

The client then recalled that a year before, when the stock market was rising, the same consultant had asked him to add in more money since the value of his investment had risen. Now the client is really confused. This will mean that any time is a good time to invest!

The truth is, the explanation given by the consultant were correct on both counts – except that they were incomplete and were therefore misleading.

Let’s look at the first situation – when the value of your investments goes up. This is a good situation because it is the reason you made the investment in the first place – to make more money. (And you make money when he value of your investment goes up, not down). When this happens, it probably means that you’re on to a winner. However, you may want to investigate further before buying more units. If the reasons that made you invest in the fund in the first place are still valid, then yes, you may want to consider adding to your investment.

But if you believe that the rise is just temporary spark or a short-term reaction to certain events, then you may want to just let it ride without adding to the investment.

If the fund continues to rise, then you will make even more money. You may want to relook the situation and analyse your earlier decision. But whatever you decision is, you would have made money, which can only be a good thing.

Now let’s look at the situation when the NAV of your fund has dropped. It is true that you would get more units for the same amount of money if you buy at this time. This strategy, known as dollar cost averaging, will bring down your average purchase price.

But this argument would mean that you continue to add to the investment when the NAV drops further. The bigger the drop, the more you should invest. Even when the NAV drop down to 10 sen, your should still be investing in it. In fact, you should add more money at this time because it is cheap, and you will really get a whole lot of units for the same amount of money.

Now you see the fallacy of this argument. Dollar cost averaging is a distorted investment strategy because it ignores the performance of the fund. Is assumes that everything is still okay with the fund, and the only thing “wrong” is the price. At the extreme case, dollar-cost averaging tells you to continue investing even when your fund is down in the dumps when all other funds are making money for their investors.

If this is the case, perhaps you should investigate further before adding more money into your fund. Perhaps there is a good reason why your particular fund is down when other funds are shooting up.

Actually, there is another better investment strategy. The first thing to do when the NAV drops is to sit back and take a deep breath. Don’t be in a hurry to buy more units to average down your cost and don’t buy just because someone tells you that it is a good time to buy because units are cheap. 

The next thing to do is to look at the performance of the fund carefully. If the NAV drops because the KLSE has dropped, then it is no reason to panic. When the market drops or crashes, the value of all funds would drop, as all the unit trust funds are linked to the stock market in one way or another. Even the best of funds are not spared. The market will punish good and bad alike.

After that, you must investigate and compare the performance of the fund against funds with similar objectives. Ideally, the performance of your fund should be near the top of the group. Is this is the case, then it is very likely that the fund is still holding steady. Yes, the value of your investment has dropped but the drop is due to the fall in the market, and not because the fund itself is underperforming.

If the reasons that made you buy into the funds are still valid, then you may want to buy more units regardless of the market direction. You may want to add to to your investment and practice dollar cost averaging.

But if you discover that your fund is indeed performing poorly – and we have all made such investments – then you may want to forget about dollar cost averaging. In fact, you may even want to sell off the investment totally. Why hang on to a loser?

To summarise, don’t practice dollar cost averaging blindly and don’t throw good money after bad. The market rises, the market falls. That is its nature. If you know what you are doing, then you should come out shining in the end.