Blog58: Is Euro-Cost-Averaging A Good Thing!?…..(Chicken & Egg Version!)

Blog58: Is Euro-Cost-Averaging A Good Thing!?…..(Chicken & Egg Version!)

Hey,

We've spoken about volatility here before, and we have put it on a bit of a pedestal on account of it's hugely positive influence on the long term saver/investor who embraces it and recognises it as the huge ally it is. Euro Cost Averaging (Or Egg-Cost-Averaging as you'll see in a moment) is an outcome of these fluctuations.

Euro-Cost-Averaging is just

one of the many aspects of Financial Planning in Ireland, which goes some way to explaining why our Financial Planning and Money Podcast here, is over 60 episodes old and we have so so much more to share with you dear readers and listeners. We are on a mission to become the place for people to turn when they need real information and insight which is un-biased and practical to Irish people who want to deliver positive financial futures for themselves....not too much to aim for!?

What is Euro Cost Averaging?

This is a jargon term the industry created many moons ago. In plain English it refers to the fact that if you are saving regularly into an investment, that investment will increase and decrease in value over time, meaning you are buying into that investment at these various points, some high, some low, which results in an average price paid.

Imagine you buy €2 worth of eggs every week from old Mrs. Corrigan (fictitious character!) up the road. The number of eggs you get for your €2 from Mrs. Corrigan on a given week is based on how much demand there is for the eggs, and how productive the hens have been that week! For example one week you get 12, another week it is 8, the following week 9, another week 10, another week 9 and another week 12. Over that particular 6 weeks you got a total of 60 eggs. You paid a total of €12, so the Egg-Cost-Average here would be calculated as €12.00/60 = 20cent per egg, over that period of time! Simple! Though we like to let on we are very smart in the Financial Services industry, that is basically what Euro Cost Averaging is!

Is Euro Cost Averaging An Investment Strategy or Just An Outcome!?

While some argue that it is an investment strategy designed to reduce volatility and 'average-out' your returns over the long term, while others suggest that it is an outcome, whether positive or negative, when an investor contributes a certain sum at regular intervals over a period of time.

We suggest it is indeed the latter. There is much research which points to the fact that as an investment strategy, it is flawed and statisticaly less likely to deliver better outcomes than investing it in one lump sum. Say you have €150,000 to invest, research suggests that it is best to invest it as one contribution instead of trying to time the markets and drip-feed it into a particular strategy over a period of time, say 12 months. You'll see why shortly.

In the USA Euro Cost Averaging is known as Dollar Cost Averaging (DCA). Finance journalist Dan Kadlec of Time Magazine summarized all the relevant research research when he wrote, "The superior long-term returns of lump sum investing (instead of DCA) have been acknowledged for more than 30 years. Similarly, decades of empirical research on DCA has found that it does not function as promoted, and is a sub-optimal investment strategy". This debate is one for another day, the main purpose of the past 2 paragraphs is to outline what Euro Cost Averaging is, and is not, and how it impacts.

So What Does Euro Cost Averaging Actually Do?

What better way to explain it than to display it in numbers. Let's imagine this weeks' character, we'll call her Grainne, starts a regular savings investment or indeed a pension where she will be contributing the same amount every month, even for 6 months:

Month 1 - Cash Invested: €300                    Unit Price: €1.00                  Units Bought: 300

Month 2 - Cash Invested €300                     Unit Price: €1.10                  Units Bought: 272

Month 3 - Cash Invested €300                     Unit Price €1.50                   Units Bought: 200

Month 4 - Cash Invested €300                     Unit Price €1.20                   Units Bought: 250

Month 5 - Cash Invested €300                     Unit Price €1.15                    Units Bought: 260

Month 6 - Cash Invested €300                     Unit Price €1.00                   Units Bought: 300

So, as you'll see from above, there was quite a lot of volatility in the first 6 months of Grainne's investment journey, that's purely for illustration purposes! The value of the fund she was investing in grew by 50% in value and came back down to the price at which she had started investing 6 months ago. How does that leave her in terms of being up, down or level!?

Grainne has at this stage invested €1,800 (6*300).  She has a total of 1,582 units in this particular investment, meaning she has paid an average of €1.14 per unit. Considering that her units are currently all actually worth €1.00 she will actually be down money, as she paid a high price for units relative to their current value, particularly in months 3 and 4! She would have invested €1,800, as we saw, and as at month 6 her fund would be worth €1,582 (1582 units * current price of €1.00!). Grainne may well feel like this has been a rubbish investment, and want to cash out her chips now, but alas we must not allow her take such a knee-jerk reaction.......

So, whats the moral of this particular story I hear you ask!? Well as you can see, if you are buying units (investing) on a regular basis, even with Euro Cost Averaging, you would be best advised to keep a hold of your investment until the value comes above the average price at which you have paid over the course of the investment journey. If you are in a pension, the timelines will obviously be much much longer, however the same principles apply.

Another moral of the story is that, if you are investing regularly, it may seem counter-intuitive really you do not want to see the value of the fund going up! At least until it is time for you to cash in your chips! You really do want to be buying them at a low price, accumulating them at a huge volume, and when they come up in value, you cash them and then enjoy the fruits of your labour! Buy low and sell high is a term we have all heard of, Euro Cost Averaging can help you achieve that......let's see how..

Does It Help Me As a Saver?

In this story we're going to outline Joe's investment journey. He is a good guy, has a great financial coach who has identified his goals, and indeed his concerns regards his retirement planning. Joe needs to accumulate a pot of €200,000 by the time he is 62 in order to allow him reduce his hours, and to support the lifestyle that he desires, in addition to his other assets he has. So off Joe goes and start contributing €600 per month into his pension....

Month 1 - Cash Invested: €600                    Unit Price: €0.20                  Units Bought: 3000

Month 2 - Cash Invested €600                     Unit Price: €0.18                  Units Bought: 3333

Month 3 - Cash Invested €600                     Unit Price €0.15                   Units Bought: 4000

Month 4 - Cash Invested €600                     Unit Price €0.12                   Units Bought: 5000

Month 5 - Cash Invested €600                     Unit Price €0.14                    Units Bought: 4285

Month 6 - Cash Invested €600                     Unit Price €0.20                   Units Bought: 3000

Joe's initial 6 months were too a roller-coaster, with his fund falling in value by 40%, from 20c to 12c at one point. In real terms this would most likely feel like armageddon again, there would be some sort of economic crisis to drive a well diversified portfolio down by 40%, but it will happen again soon, mark my words! So, despite this sense of panic around the place, thanks to the strong financial coach that is working with Joe he persists and has faith in the constant upward curve that is global equities, and he actually end up big-time in the green.

Joe has invested €3,600 at this stage, he has a total of 22,618 units. Divide one by the other and we can see that the average price Joe has paid for his units has been just under 16cent. They are currently worth 20cent, so his €3,600 is now worth €4,523! And that was having gone through a financial crisis that had eroded 40% of the value of his fund at one point!

Moral of the story for Joe? If you are regularly investing through a crisis that smashes the value of your investment fund, you are buying cheap, you are accumulating huge numbers of units at a discount......it's like a Next Sale in Blanchardstown Shopping Centre.....except at this sale every eejit in the country is quite wrongly telling you to keep your money in your pocket/deposit account....more fool you if you listen to them!!

How Would It Have Gone If They Invested a Lump Sum?

The funny thing is that if Grainne had of invested a lump sum in month 1 instead of regular payments over the 6 months, she would be in the same position she started, having paid €1 per unit at the start, the same point it was at by the 6 month point. So for her, you could argue that she'd have been better off doing a lump sum, but you can only say that based on the value it is right now.......

If Joe had invested a lump sum, he would be breaking even at this point also. He is better off having paid regularly.

The moral of that story?! Nobody can tell what the markets will do, it is not a debate to get into, should I aim to Euro-Cost-Average or will I go with the Lump Sum, impossible to answer, it's a bit like the old chestnut of a question, 'Should I Fix my mortgage or go with a variable rate'!? Impossible to predict future rates/fluctuations.

What some would argue however, is that based on the fact that equity markets are positive more than 70% of the time, if you dollar-cost-average your way instead of going with a lump sum at a particular point in time (if you have the lump sum available) you will more than likely be paying higher prices by purchasing at more points in time.

This debate of Lump Sum or Dollar Cost Averaging is for another day, so this might just whet the appetite!

Thanks,

 

Paddy Delaney

QFA | RPA | APA | Qualified Coach

 

 

No Comments Yet.

Leave a comment