Just to be clear. I’m still sticking to my Dollar Cost Averaging (DCA) and Value Cost Averaging (VCA) of index ETFs and robo-advisor accounts strategy. This post is my attempt at understanding how investing in ETFs can be a problem as more and more people engage in it. Specifically when people in different age groups, personal and financial circumstances invest in index ETFs.
My index ETF portfolio gives me broad-based exposure to various geographical and specific segments of equity markets globally. Although I achieve diversification, I pay a price in the form of only getting market returns on the index ETF portfolio. For your information, market returns is nothing to shout about. It’s probably the main reason why people still gravitate towards investing in stocks and other financial assets to obtain higher than market returns.
For market returns on index ETFs to work, you need to have a large cash savings and investment capital base. If you don’t have enough cash funds to invest in index ETFs, you are likely to find that the market returns is insufficient. In the event of a personal financial crisis, the low dividend yield on an index ETF portfolio means that you don’t have enough dividend income to sustain yourself. Which results in you selling your index ETF portfolio holdings first when the price is low and losing out on any subsequent market recovery.
The most powerful advantage of an index ETF portfolio is that the broad-based equity exposure allows you to tap into the market cycles of multiple businesses all over the world. A listed business available for public investment via stock markets is either growing or declining, either making profits or losses. Technological advancements mean that new businesses keep cropping up and old businesses keep dying at an increasing rate.
As the business market cycle becomes more unpredictable and you become busier with family and work commitments, the difficulty level of understanding the business market cycle well enough to profit from it rises. Which is why you now have people in different age groups, personal and financial circumstances switching to index ETFs to manage this risk.
This becomes a problem when you are in the group that cannot sustain this strategy in the long run because of insufficient cash savings and investment capital. Let’s run through an example of how this can happen.
You have S$10,000 of cash savings and S$10,000 of cash investment capital. I have S$100,000 of cash savings and S$100,000 of cash investment capital. We are both investing S$1,000 per month into index ETFs from our salary incomes. The economy is chugging along and our jobs are stable for now. The price of index ETFs is usually high during this time. Dividend income from the index ETF portfolio is only sufficient for basic living expenses.
A recession is triggered for whatever reason but we hang on to our jobs. The price of index ETFs drop and this is where the benefit of DCA comes in since we are still investing S$1,000 per month. We might even increase our monthly investments into index ETFs to S$1,500 per month. But we don’t change our investing strategy and continue to ignore the price of dividend stocks dropping. Switching now will expose us to individual business risk that we have not prepared ourselves to understand properly.
The problem starts when the recession worsens and we both lose our jobs. We want to take advantage of the even lower price of index ETFs. However, without salary income to sustain the monthly investments, we both tap into our cash investment capital. Remember that our cash savings is now being drawn down for monthly expenses since the dividend income was low to begin with and has dropped even further as dividends get cut.
You can last for about a year before you stop the monthly investments. From that point, you have to start selling portions of your ETF portfolio to manage the monthly expenses. Right when price of index ETFs is low. I can last for about 5 years before I have to stop. Let’s assume we are both jobless for a few years. A prolonged recession can last for about 5 years before the subsequent market recovery. By then, you have run out of cash savings and investment capital. With no index ETF portfolio, the subsequent market recovery does you no good. But the DCA would have worked in my favour the entire time.
When we eventually get jobs after a few years, my ETF portfolio would have rebounded and grown bigger but your ETF portfolio has to be started from scratch again. But this time round, you might look to take on more risk and build a dividend stock portfolio instead. Just to increase your dividend income to manage more than your basic living expenses.
However, the same problem exists with your insufficient cash and investment capital. But this time round, you are more exposed to individual business risk and market cycles. In fact, some of the listed businesses you invested in might not survive the next recession. While such stocks just drop out of index ETFs and get replaced with new stocks, the ETF portfolio holdings value doesn’t get wiped out unlike the individual stock holdings value.
Look at how index ETFs can work against you when you least expect it. I’m starting to realise that a long-term index ETF investing strategy works best if you have large cash savings and investment capital. By investing in the equity markets of various geographies and specific segments globally, you essentially tap into the growth of new businesses and limit your exposure to the collapse of old businesses. The upside is limited but more importantly, the downside is capped.
If you can last through the downturn and bear market cycle, you put yourself in a strong position to benefit from the subsequent growth. If you can’t sustain it, you may end up losing more than if you hadn’t built an index ETF portfolio in the first place. None of our index ETF portfolios have been tested so far so there’s no way of knowing who can survive then. The question is whether you have sufficiently prepared your other assets for the challenge.