Buying Low and Selling High
For us to know when to buy low and sell high, we should have an indicator for entry into the market and likewise, for exiting the market. To illustrate the strategy, let us turn to our favourite Straits Times Index (STI) as an example. (In this article, all PE ratios are estimated PE ratios).
The first step is to have our fair PE ratio. The fair PE ratio suggests a fair valuation of the index. When the current PE ratio is far below its fair PE ratio, the STI can be considered as relatively cheap. To have a proper gauge, we can consider a PE ratio below one standard deviation of the fair PE as an indication for cheap. Conversely, a PE ratio above one standard deviation of the fair PE would be considered expensive.
Chart 1: STI Estimated PE Ratio
The PE ratio of STI sits at 12.5, a value which would indicate buying low.
Chart 2: Straits Times Index Price Chart
Is the next leg up or down?
The Strategy
To have a hard and fast rule for buying low and selling high, we consider a simple strategy – we invest in the index if the estimated PE ratio is below 1 standard deviation of its average and divest when the estimated PE ratio reaches 1 standard deviation above its average.
For times when the estimated PE ratio is ranging in between the two boundaries, we will hold our position and also not invest in the index.
Take the S&P 500 Index as an example.
Chart 3: Est. PE Ratio of S&P 500 Index from Jun 05 to Sep 18
We would invest in the index whenever the PE ratio falls below 13.15 in this scenario and divest it when it exceeds 16.85. As such, we try our best to achieve the saying of “buy low and sell high”.
Dollar-Cost Averaging (DCA)
For DCA, we buy the index at the end of every month with a fixed amount of money throughout the whole period. This simple strategy accumulates more units when prices are low and buys less units when prices are higher.
The Experiment
As we are unable to test this strategy on future prices, we simulate an investor trying out this strategy using our fair PE ratios in 2005, when we started having data on estimated PE ratios.
The strategy will be tested on stock indices from across the world and will be competing against the standard strategy of dollar-cost averaging. The two strategies will be divested at prices as of end-September 2018 and the winner will be the one with the higher sum. Fees and charges will also be ignored, while dividends will be re-invested to give us total returns.
Will it Work?
We ran the strategy and dollar-cost averaging on a few markets with a global investor perspective. The table below shows the results (click on the link to look at the charts).
Table 1
Buy Low, Sell High |
Dollar-Cost Averaging |
|
4.26% |
6.53% |
|
3.73% |
6.47% |
|
5.30% |
5.65% |
|
2.74% |
3.77% |
|
1.98% |
2.50% |
|
Annualised returns from Jun 05 to Sep 18 |
||
Source: Bloomberg, iFAST compilations |
||
Looking at the results, it is fair to say that dollar-cost averaging performed better from Jun 05 to Sep 18. Upon looking into the details, there are some flaws in the automated strategy, with the most obvious one being seen in the case of Nikkei 225 Index.
Delving Deeper
The point of selling when the PE ratio exceeds one standard deviation of the fair PE is to protect oneself against a drawdown as the index is deemed expensive. However, this may backfire when prices are low but earnings are even lower, thus resulting in a high PE. For example, Japan in 2009.
Chart 4: Nikkei 225 Backfires
Selling at a loss. (Similar for MSCI Asia ex Japan and MSCI Emerging Markets.)
Furthermore, an extra benefit of DCA is that your units will enjoy compounding returns, provided the stock index goes on a great bull run.
Chart 5: U S A! U S A! U S A!
Missing out on 50% returns. (Similar for STOXX 600 Index.)
Granted, this strategy may protect you from a potential drawdown, however, you could missed out on higher returns too. DCA provides you with a hassle-free investment strategy and is also more reliable.
Some of you might argue that introducing some flexibility into the system may result in higher returns. However, who is to say that you will not flip-flop when prices are low or high?
DCA Goes Through Heavier Testing
To put DCA through the trials of time, we tested it on the S&P 500 Index using data from 1950 – 2018. We ran it on 5-years, 10-years, 15-years and 20-years periods on a rolling basis to give us the below results.
Table 2
5 Years Period |
10 Years Period |
15 Years Period |
20 Years Period |
|
Number of Periods |
765 |
705 |
645 |
585 |
Average annualised returns in USD terms with dividends reinvested |
5.87% |
5.67% |
5.76% |
5.97% |
Minimum Returns |
-8.97% |
-3.76% |
-0.59% |
1.64% |
Maximum Returns |
15.45% |
12.20% |
11.22% |
11.28% |
Probability of Positive Returns |
91.9% |
97.4% |
99.7% |
100.0% |
Source: Bloomberg, iFAST compilations |
||||
Looking at the results, we can conclude that doing DCA for a longer period of time is most beneficial, both in receiving higher annualised returns and almost guaranteeing positive returns. (We have discussed the benefits of a longer investment horizon in this article.)
Furthermore, during a market downturn, you will be accumulating more units. Consequently, you should have a longer investment horizon to wait the downturn out and participate in the recovery.
Holy Grail?
We have come a long way and ended up at the long repeated conclusion of utilising DCA as your investment strategy. At FSMOne, you can start doing dollar-cost averaging today using a simple regular savings plan on our recommended funds (just tick the checkbox). If you wish to leave the investment to us, you can consider investing in our managed portfolios (FSM MAPS).
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