O.K., we've heard it a million times. 50% beginning cash reserve is too conservative for starting a PCA holding in your favorite stock. Let's explore the actual numbers and see just how the beginning cash reserve affects the long-term performance of PCA.
First a thought to ponder, if you think that there is any chance in the world of a Bear Market over the next few years, you should definitely start with no less cash reserve than 1/2 the initial portfolio value.
You see, actual Bear Markets have never been experienced by most investors. If a real one comes along, average stock prices could plunge 50-70%. This would be consistent with history, and the scariest thing is that the majority of stocks will get crushed, even today's leaders.
As a PCA user, you already know that the system will be buying on the way down, lowering the average cost per share at every incremental price level. We must make sure that in the event of a Bear Market, we are positioned to have enough cash to really capitalize in the long-run.
Since the PCA system is based on percentages, let's create an example to illustrate what could happen in a Bear Market with a stock that loses 70% of it's value.
To begin, we'll use an example where a PCA holding is created with $10,000.
We buy 500 shares of stock at $10 and put the other $5,000 into our cash reserve.
The stock begins it's 70% plunge from 10 to 3, $1 at a time:
At $ 9 a share, no trade is signaled.
At $8, (20% dip) we get our first buy using 12% of the initial cash reserve ($600) to buy more shares.
When the price reaches $7, (30% dip) we use another 17% of the initial cash reserve ($873) to buy more shares.
Now at $6, (40% dip) we consume 22% more of the initial cash reserve ($1119).
It's interesting to note that at this point, the buy and hold investor is down a full 40% while the PCA investor shows only a 23% loss on the portfolio. Also, notice that the PCA investor has lowered his cost to $8.57 a share, while still maintaining a 69% to 31% stock to cash ratio. The most interesting thing is that the PCA investor is only down $275 more than the lump-sum investor who put all his cash in at 10. We're at a 40% price drop here!
Let's see what happens when the stock has plummetted a full 50% to $5.
Surprise, we're buying again! this time (gulping), we purchase $1422 more or 28% of the cash we had allocated at the start. This leaves us with $987 left in cash. Just about 20% of the initial cash. It's interesting that on default settings, PCA will invest 80% of the cash reserve when the stock gets cut in half. Seems like a reasonable proposal.
Now here is the really crazy part. When the stock gets to $5, PCA will signal another buy right away if the price of $5 is entered again!. PCA asks you to buy another $569 worth of stock. This seems to make no sense. If you got a signal to buy $1422 at 5 the first time, why would it want you to buy another $569 if the price hasn't changed?
First of all, this is the part of the system that is saying "prices are very low, and if they continue to be this low, additional shares should be accumulated". Also, if we skip entering the $5 the second time and go right to $4, PCA does not have the available cash to execute that trade. We are exactly $870 shy in our cash reserve to make the buy. We could of course choose to add the additional $870 to the reserve, which would give us a buy of $1856 at $4.
This is also where the "time" vs. Price factor comes into play.
Seasoned PCA investors know that there are 2 ways to manage the system. Price or Time.
The Price method dictates that the trade will be executed at the first possible signal, and the price at which the next buy and sell are should be set as "Good till Cacelled" limit orders with their broker.
The Time method is more "by the book" and can result in considerably differing results using the Price method. Say you only updated your PCA on Friday morning. Perhaps you missed the initial drop from 10 to 8, and instead plugged in $7 for your first subsequent price. The result would be to buy in with 23% of the initial cash right off the bat rather than the 12% had we executed when the price was $8. Interesting.
Let's get back to our Bear Market scenerio. So the price has dropped from $10 to $5, and we are making our second buy at $5. At this point, PCA will not make any more buys as he price drops to $3 unless more cash is added. Notice however that PCA still keeps $1288 in cash. I guess you could choose to put that in as well at some point becoming fully invested in the "debacle".
So here we are. Our stock price has dropped from $10 to the bottom at $3. Wait a minute, we still have 26% of our original cash in reserve! We have $1285 out of the $5000 beginning cash. Not bad really. Perhaps we should go ahead and kick it in at $3? Perhaps we should use it for a vacation instead!
OK, now let's see exactly where we stand and how we compare to the lump-sum investor who took the same $10,000 we used to start our PCA holding. First, the lump-sum investor has 1,000 shares with an average cost of $10. It's a long way back if he didn't dump the stock right away. He has lost 70% of his original investment.
The PCA investor has 1284 shares at an average cost of $7.46, and is down only 53% on a stock that dropped 70%. Definitely not something we want, however this is meant to be an eye-opener for anyone using the system. Remember, this is all predicated on using a fully funded cash reserve of 50% of the portfolio value to start.
Now, we can see that our break-even level is $7.46 a share or 25% below the cost of the lump-sum investor. Just for fun, let's say that the stock had a miraculous jump back to $10 right away with no selling on the way up. If you enter a price of $10, PCA sells 427 shares, creating a profit of 30% on the portfolio!. The lump-sum investor is now only even and probably has an ulcer! This sell at $10 by the PCA investor converts $5,555 back to cash, more than we started with.
Back to our original example. The stock has bottomed at $3 and is on the way back to $10. (3-4-5-6-7-8-9-10). We will spare the details of the selling on the way up and look at the final results.
Once the price has reached the original buy price of $10, PCA shows a 23% return with $5185 converted back to cash. Remember, the lump-sum investor is just now even. Our current cost is $6.93 a share and we own 820 shares. We have more cash than we started with and we have 64% more shares. Not bad if you have nerves of steel, and a stock that has staying power.
This example can be applied to any stock, which is why you should think long and hard before deciding to start a PCA with less than 50% in cash. A $42 stock would only have to go to $12.60 to have a 70% decline. We see things like this happen all the time in today's market. Imagine what a real Bear Market would do the average stock.
To summarize, even though the chance of your stocks plunging 70% seems near impossible, it is prudent to observe what the results would be. If nothing else, it demonstrates the rate at which our cash reserve will be consumed, so we can plan our initial parameters. It's very plausible that in a Bear Market, the likes of which have not been seen in over a decade, Blue-Chip stocks could drop 70%, and the PCA investor would be in much better condition to weather the storm and come out on top once the cycle turns for the better.
Don't let "irrational exuberance" keep you from fully funding your cash
reserve from the beginning. Some day, you may need it. Just breathe deep and say "Thank goodness I didn't jump in head-first without first testing the waters".
Good Luck and may you never have to commit your entire reserve!
Why You Should Start Your PCA 50% Invested
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