Long-term strategies for prudent investors

There’s an excellent example from Warren Buffett that illustrates how long-term investors should tackle market volatility. It perfectly encapsulates the mentality of what the ultimate purpose of investing is: to sell an asset at a price higher than what you initially paid for it. I’ll let Buffett explain in his own words:

“A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices?

These questions, of course, answer themselves.

But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the “hamburgers” they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.”1

Buffett is right, it defies common sense to hope for rising prices for something you’re going to be buying. Only when you’re looking to sell should you hope that prices rise, so you can abide by the most basic investing rule: buy low, sell high.

Formula-driven investing

Michael Edleson wrote the book Value Averaging back in 1991 in which he argued that people should employ a "formula" to increase the chances of success when investing in the stock market. One such formula is called Dollar Cost Averaging (DCA) and it sounds a lot more complex than it actually is. All DCA does is reduce the average cost of your equity holdings because when prices drop you’re acquiring more shares at cheaper prices. This assumes, of course, that the market doesn’t trend upwards indefinitely, which it doesn’t.

Edleson was an advocate of formula strategies that are nothing more than passive guidelines, much like active traders who use charts and other technical indicators to time the market, or at least try to. Edleson said these strategies are meant to be “automatic and mechanical, the very antithesis of the emotional involvement inherent in timing strategies.” He continues on with a very poignant message to the aforementioned day traders attempting to time the market: “Remember that if timing systems were developed that could truly consistently beat the market, they would not be viable for very long. If we all jumped on the same bandwagon, we’d all get the same return—the average return.”2

DCA is an excellent buying strategy over relatively long periods; however, when it comes time to sell, DCA really doesn’t help investors because under the strategy, there’s no periodic plan to trim equities for cash, which essentially means that the investor had better be selling at a time when prices are higher relative to what their cost basis has been. Enter value averaging.

Value averaging (VA) is a formula-driven strategy whereby an investor sets a return that he or she wants to earn in the market, say 10%. Instead of putting their investment strategy on autopilot and investing equal sums each month (DCA), he or she sells a bit when profits rise above their 10% target, and when the market isn’t living up to the 10% goal, additional purchases are made, thus adhering to the buy low, sell high strategy, but in this case, you’re selling point isn’t a guessing game, and your increased buying is further reducing the average cost of the stocks you own.

For example, take that 10% annual return target, which equals about 0.79% monthly, accounting for compounding. If you had $500 to invest on a monthly basis, after the first month the value of your account would be $503.95 at a 0.79% rate. If, in that first month, you check your account and you actually had $520, you would’ve earned a rate higher than your target of 0.79%, thus you could sell the difference of $16.05 and use it to perhaps buy more securities in a down month. It must be said that this one-month hypothetical example is neither long term nor is it taking into account transaction costs or the tax recognition of capital gains, both of which would negate the increase in returns.

If the market happened to decline over that first month, you would add more than $500 to obtain an expected growth rate on target with your 10% goal. The assumption is that markets fluctuate and instead of trying to time the ups and downs of the market, investors can simply sit back, trim some holdings during market highs, buy more during market lows, and ultimately achieve a return higher than you would if you were merely dollar cost averaging. During the Dotcom bust, had you been value averaging with a Nasdaq index fund from 1991 to 2005, you would have made a 15.2% return, as compared to a 9.6% return using DCA.3

No perfect plan

Another pitfall to the value averaging strategy that Edleson described is that it doesn’t take into account cash drag, which is the lagging performance of having some capital sitting in cash awaiting for a market decline to buy more than your predetermined monthly stock purchases. After all, you could have that cash working for you in the market, instead of simply sitting on the sidelines earning next to nothing.

Overall, DCA is a very effective method of investing and the simplicity of it makes it attractive to those looking to invest over the long haul. Likewise, value averaging can provide investors with another way to increase returns over extended periods of time, albeit with more attention to monthly returns and perhaps increased costs associated with tax liabilities and transaction fees.

The key takeaway is that both strategies attempt to provide the investor with a method to increase the chance that they're buying low and selling high, irrespective of what the market is doing.

1. Berkshire Hathaway Inc., 1997 Chairman’s Letter http://www.berkshirehathaway.com/1997ar/1997.html

2. Edleson, Michael E. (2008-04-21). Value Averaging: The Safe and Easy Strategy for Higher Investment Returns

3. Hallam, Andrew. Is Value Averaging Your Answer To Stock Market Timing? August 11, 2014