Is dollar cost averaging a suitable stock market investing strategy for beginners?
In this article I will describe what dollar cost averaging is and how beginner investors can put it to good use. From my recollection, Benjamin Graham (the father of value investing) proposed that the use of "formulas" like this was a good way to protect investors from themselves by reducing the risk of investors trying to time the market.
What Is Dollar Cost Averaging?
As I've already said, dollar cost averaging is a stock market investment strategy (or a form of formula investing). The basic idea is that an investor buys stocks at regular intervals thereby 'averaging' their purchase price. The advantage of this method is that investors avoid putting all of their their money into the stock market right at the top or just before a fall. By buying stocks in smaller amounts on a regular basis, you will be buying right through the stock market cycle - both the ups and downs.
Is Dollar Cost Averaging For You?
I have to admit to being a little cynical when it comes to dollar cost averaging. Sometimes it seems to be more of a marketing gimmick employed by mutual funds and other purveyors of investment products. They seem to use it to promote products whereby you buy shares or units in their mutual fund on a monthly basis. And you can understand why - they put a lot of effort into convincing you to part with your money, so rather than getting you to buy once they get you onto a regular plan. They will even take the money out of your pay to make it easier.
However, I think there are some scenarios where dollar cost averaging may be worthy of consideration.
I think the principle of regular investment is sound. It can help prevent a new investor putting all of their money in at the top of the market. Also, in uncertain and volatile times (such as we're experiencing at the moment) it can help prevent investor procrastination. By that I mean an investor who sits on his (or her) hands waiting for the market to bottom out only to wait too long and miss the start of the recovery. Or they might try to pick the bottom and invest once they see a recovery under way, only to find the recovery short lived and the subsequent downturn takes the market to new lows.
In this situation, a regular investment program can help the investor psychologically. By committing a portion of their capital this month, then another portion the following month, they can cover both cases. If the market does recover, they can take solace in the fact that they bought in at lower prices. And if the market continues its downward trend they still have the funds available to make purchases at lower levels.
Another potential positive of dollar cost averaging as a stock market investing strategy is in its use as a regular savings plan. In my opinion a regular savings plan is a great idea regardless of what shape or form it takes. If by drip feed investing a portion of your pay or salary into a financial market you are able to accumulate and growth your wealth then I'm all for it.
In the past, I've used a form of dollar cost averaging at times of market uncertainty - including the most recent downturn. Rather than trying to indulge in market timing by picking the bottom of the market, I would buy the stock which provided the greatest value at the time I was buying. With financial markets plummeting, I was concerned about the risk of investing all of my money only to see the market drop by another 10% or more. Regardless of how objective I try to be, the idea of purchasing stock, even for the long term, only to see it keep falling is an unpleasant one. But by keeping funds in reserve, I'm able to purchase that or other stocks at the lower prices. Please note that this is where I'm confident of the long term prospects of the company in which I'm buying stock.
So, as you can see that even though I have my concerns about dollar cost averaging, there are times when it may be useful. But as with the application of any stock market strategy, it should revolve around the purchase of quality stocks.
Monday, May 26, 2008
Wednesday, May 21, 2008
What is debt to equity and how can it help beginners when investing in the stock market?
A company's debt to equity ratio or it's gearing ratio is a measure of the level of borrowings a company has used in proportion to stockholders' equity to finance it's assets. It's often used as an indicator of the amount of risk inherent in the shares of a particular corporation.
How To Calculate Debt To Equity:
In it's simplest form, the debt to equity ratio formula is as follows:
Debt To Equity = Total Liabilities / Stockholders' Equity
While there are many variations on this basic formula, I find this one to be easy and convenient to apply. Both these figures are readily available in the Balance Sheet contained in a company's published Financial Statements. Variations are mainly around what is included in the Total Liabilities. I've seen some analysts subtract cash on hand from total liabilities or leave working capital out altogether.
The only major difference is when gearing is measured as debt to total assets (or debt / (debt + stockholders equity). Using these figures will normally give a materially different result. The reason I mention this is that gearing ratios and debt to equity ratios are sometimes used interchangeably and you need to understand whether gearing is being quoted as debt to equity or debt to total assets.
Why Do We Care About This?
I mentioned earlier that it can be used as an indicator as to riskiness of a stock market investment. Normally a company with more borrowings is seen as being more risky than a company with less. This is because these loans, or more specifically, a company's ability to service it's theses loans, is key to it's survival. If a corporation fails to pay interest on borrowings on time or is unable to repay the principal when it falls due, it's creditors' may move in. In the worst case scenario, insolvency could result and that could lead to significant or even total loss of capital for investors.
So why do companies borrow money at all? It's not all doom and gloom. When managed correctly, gearing can be used to help grow a business, leverage shareholders' capital more efficiently and ultimately increase returns to shareholders. If a business can borrow money at 7% and generate a return of 10% on those funds, the excess earnings will accrue for the benefit of holders of the company's stock. This means higher profits and more money to invest in growing the business or to pay out as dividends. That's why the use of borrowed money is sometimes described as leverage.
But, interest rates vary over time and corporate profits fluctuate with the business cycle. What happens when interest rates rise? Can the company still meet it's interest obligations? And similarly, as the economy slows and cash flow drops, can its loans still be serviced. The recent (ongoing?) sub prime crisis also illustrates what happens when borrowings fall due and companies are unable to refinance. All of this illustrates why I prefer to invest in the stock of companies who use borrowed money conservatively.
What Is A Good Debt To Equity Ratio?
As with much of what goes with investing in the stock market, there is no hard and fast rule here. It will depend on the company and on the industry in which it operates. Capital intensive businesses will tend to have higher debt to equity ratios. Businesses that have reliable earnings (ie. earnings which don't fluctuate much through economic cycles) like utilities and consumer staples can normally sustain higher gearing ratios as well.
You could apply a rule of thumb and say you'll steer away from businesses whose debt/equity ratio is greater than 1 (ie. it's financed more through borrowings than through stockholders' equity) but you may exclude some industries altogether. However, this may not be a bad thing as some may argue that corporations which require large amounts of borrowed funds probably don't have very strong businesses - I believe Warren Buffett is said to prefer the stock of companies with low levels of borrowing. When looking for prospective investments, I look at a company's debt to equity ratio over time and also compare it against other companies in the same industry.
Another useful stock market ratio is interest coverage or times interest earned. It measures a company's ability to service it's loans. The higher the coverage the better - there's more leeway if things turn sour. I'll write more about this in an upcoming post.
Some of my biggest mistakes in my early beginner attempts at investing in the stock market were the result of high debt. That's why I always consider debt to equity as part of my stock analysis.
Update: I've since written a post on the Quick Ratio, another useful indicator of the financial health of prospective stock market investments.
