Tag Archives: Dollar cost averaging

Gains with a negative performance?

I wrote some months ago a post in the blog where I showed how you lose money with swings in the market of the same percentage (e.g. -10% followed by +10% or vice versa).

In another post I explained how mutual open-ended funds define and calculate their performance based on the changes in net asset value per share.

In this post I wanted to point at some fine detail: a mutual fund may have a negative performance in a period of time (e.g. a year) yet have gained positive results during the same period. How is that possible?

As I mentioned in that previous post, the net asset value per share of a mutual fund rises and decreases as the aggregate share prices of the stocks in the portfolio rise or decrease. However, each time that there is an addition of capital, it is treated as an issue of new shares at the current price. It doesn’t matter whether those shares are issued to new or old “shareholders”. Depending on whether the net asset value has increased or decreased they are acquiring the new shares at a higher or lower price than they acquired the previous ones.

If it was the case of a company, we would say that shareholders would see their share diluted. In the case of a fund, the share of the ownership is also diluted, but that doesn’t mean a reduction in the net asset value per share, since with the new investment there is an increase of the assets of the fund (and the funds will be invested). Now, let’s see it the case with one example.

Take a fund with only one investor, A, who at the beginning of the year invested 10k€. That would be the assets of the fund at that moment. The net asset value per share could be defined as 100€, meaning that at that point there were 100 shares.

During the next months the market goes down and, along with the market, the fund’s assets. Let’s say that the reduction in value has been of 50% at half-way through the year. This means the assets of the fund would be 5,000€ (belonging to the sole investor, A). Since there were 100 shares, now the net asset value per share would be 50€.

At this low point, another investor, B, invests another 10k€ in the fund. Now, the 10,000€ would buy not 100 shares, but 200 at a price of 50€. The net asset value per share would remain unchanged at that moment, 50€. However, the assets of the fund would now be 15,000€. The total number of shares would be 300.

Imagine that during the second half of the year the performance of the fund is +50%. As I mentioned in the previous post, with consecutive market swings, -50% and then +50%, you lose. However, in this case there as been an investment in the low point and we’ll see what that means to the fund and each of the investors.

The +50% performance means to the fund an increase of its total assets up to 22,500€, or a net asset value per share of 75€ (for the same 300 shares). This is a +50% since mid-year, but a -25% from the beginning of the year. Quite a negative performance. However, the fund has received inflows of 20k€ along the year and has ended the year with +2,500€ of net gains!

For investor A: the year has meant the same -25% in both net assets and performance as he has lived through the whole period the big destruction of value in the first semester and the creation of value in the second, but, with the market swings of equal percentage value, he lost.

For investor B: the second semester has been great, as she has only lived the +50%, meaning a net gain of 5,000€.

Performance of an investment fund.

The asset manager of the fund hasn’t been in the whole a better performer allocating assets than the market, and that is what the net asset value shows. The fund has only gained in absolute terms because there was an investment at the low point.

This is nothing more than one of the points the proponents of the technique Dollar Cost Averaging defend: to invest regularly the same amounts of money to take benefit of bear markets, when the fixed amount of money may afford more shares of a given stock. In that way you don’t need to time the market to benefit of low points.

Or in another way: “Be fearful when others are greedy, be greedy when others are fearful”, Warren Buffett.

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Active investment fund managers

In a previous post I showed the evolution of stock price for EADS and the target price calculated by an investment bank along 34 months. I already stated the misguided recommendations that they provided. A truly “Buy high and sell low”, the quickest way to lose all your savings.

There are many advertisements of investment funds using the term “active” (active management). That’s truly dangerous regarding investing. It not only implies more expenses paid in commissions, but also implies a manager who is acting more.

Imagine that the active fund manager was the same person who had produced the investment bank’s report of EADS that I showed in my previous post. If he had been as active as he recommended his clients to be, he would have bought shares in 6 different moments between 2005 and 2006 and sold them at the beginning of 2007 (*).

As an example, I made the calculation using around 1,000€ as the amount invested in each of those points in time (using the technique called “Dollar cost averaging“). You may see in the table below how many shares those 1,000€ afforded to. You may also see the amount it could cost in commissions (of course, professional brokerage firms would get lower fees – nevertheless, if you omit that commissions, the net result at the end would have been negative as well).

Quick way to lose your savings: follow the advice of an investment bank.

As you can see, after the 7 operations along 2 years, the manager would have lost 268€ on an investment of almost 6,000€, that is losing 4,4% or about 2% a year… It is much better then to leave your money in a savings account.

Nevertheless, what is more worrisome is the fact that in the period of 34 months, the bank produced 15 different target prices, changing its recommendation (i.e., from “buy” to “hold”, etc.) up to 5 times. This urge to produce new figures and even worse, to act upon those new figures is what makes most of professional investment fund managers a truly dangerous species. As Charlie T. Munger wisely says “Resist the natural human bias to act”.

(*) I would have loved to have performed the same analysis with a newer report, as the price of EADS stock went even below 9€ in the years that followed to reach over 24€ again in 2011… but the last report of EADS (or any other company) that I had with such detailed explanation of target prices was this one (and I’d never pay for such a paper).

EADS share price since its creation.

Note 1: You may think that the negative figures reached with this example are due to the case selected. If you think that is the case, I invite you to take another example and share it with us. I do not have many such reports available, and as I already stated, such a report is not something I would be willing to pay for, I can find many more useful ways to spend money.

Note 2: If you think I was biased by using frequent buys of 1,000€ each one and selling everything at once, I made the same calculation imposing that the manager used the technique “dollar cost averaging” also at the time of selling, that is selling about 1,000€ each time the recommendation was “sell”. The result: at the end of the period he would have 2,962.5€ in cash and 2,114.6€ in stock, having lost this time nearly 16% of the invested amount, even worse than in the first case.

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