Dollar Cost Averaging
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Dollar Cost Averaging (DCA) is the practice of investing a fixed dollar amount at regular intervals in a particular investment or portfolio. Most investors contribute periodically to retirement accounts and believe "timing does not matter, if you are in the long run". Table 1 shows the returns of investing a fixed monthly amount over last 20 years for five types of portfolio.
Table 1: Average Annual Returns for different portfolios
|Portfolio ID||Portfolio Type||Return (2004)||Return (2009)||Comments|
|Portfolio A||100% Stocks||10.1%||3.9%||100% Stock Portfolio invested in S&P500 index|
|Portfolio B||100% Bonds||5.8%||5.3%||100% bond portfolio invested in 10 year bonds|
|Portfolio C||70% Stocks -30% Bonds (70-30)||9.0%||4.3%||70% investment in S&P500 and 30% in bonds|
|Portfolio D||70-30 Portfolio-Rebalanced Annually||9.2%||4.7%||70% investment in S&P500 and 30% in bonds; Portfolio is re-balanced annually|
|Portfolio E||70-30 Rebalanced and Yield Management||9.5%||5.0%||70% investment in S&P500 and 30% in bonds; Investment in stocks driven by stock yield comparison to bond yields. Portfolio is re-balanced annually;|
Note: Returns simulated by investing fixed amount per month starting in Feb 1989 in the S&P500 index and 10 year bond based on portfolio mix and strategy
As seen from the rate of returns table a 100% bond portfolio (Portfolio B) would have been better than stocks (Portfolio A) or a diversified portfolio (Portfolio C). Although 100% bond portfolio would have fared better in 2009 there are periods in between (2004) when stock portfolio (Portfolio A) would have outperformed.
To benefit from high stock returns and stable bond performance, investors need to have a diversified portfolio but more importantly need to devise stock market timing strategies. Simple strategies which require the portfolio to be rebalanced (Portfolio D) to the target diversified mix and avoiding stocks when the bond yields are higher (Portfolio E) can enable timing the market and improve the returns. Although these strategies do not provide the complete benefits of accurately timing the market they are better than a blind faith approach in DCA and an over reliance on a long term horizon.
Dollar Cost Averaging
DCA allows investors a "self control" mechanism to save towards their retirement. It allows investors to buy stocks at low average prices during any one year where stock market is expected to be end higher (typical bull market). On the other hand if the stock price at the end of year is expected to be lower (typical bear market) investors do not benefit by DCA and are buying stocks at higher price. Stocks generally outperform bonds over a long term but this is true for a one time investment and not for periodic investment in stocks as seen from the returns in Table 1. The performance of periodic investments versus one time investment is influenced by multiple factors: 1. The stock market may reach extreme heights and have a course correction at the end of the period. Contributions during the extreme heights (e.g., 1995-2000) will result in buying stocks at much high prices and the losses on those purchase outweigh the gains 2. A bull market increases the likelihood of increasing wages and salaries. Most investors have a fixed percentage contributed to savings, resulting in increasing the dollar investment when markets are rising. The opposite occurs in bear markets where people are likely to loose jobs and reduce or stop investing 3. Investors are likely to increase the % of the savings towards stocks during "bull markets" and decrease it during "bear markets" which is the exact opposite behavior
The above factors result in a "Buy High and Sell Low" strategy reducing portfolio returns as seen in Table 1. These returns do not include the negative effects of factors 2 and 3 so actual results for investors could be worse than shown in the table. Benefiting from stock market requires investors to devise market timing strategies versus relying on the false sense of security from DCA and long term horizon.
Simple Market Timing Strategies Investors can benefit from two simple strategies to time the stock market which do not require substantial know-how or time investment:
1. Portfolio re-balancing (Portfolio D) 2. Stock versus bond yield comparison (Portfolio E)
1. Portfolio Re-balancing: This strategy requires investors to periodically (e.g., annually) rebalance their portfolio to the original diversified mix. It is critical to be disciplined about this since the portfolio mix may not change by large percentage points every year. Portfolio balancing results in naturally timing the market since a percentage of asset classes that have increased in value are sold and gains are locked in. Investors need to follow the same discipline as DCA by balancing between different stock asset classes (e.g., domestic, international) and between stocks and bonds. This approach does not require significant time or stock market knowledge and increases the return without added risk.
2. Stock versus Bond yields: This strategy compares stocks yields (Dividend Yield + 1/PE Ratio) to bond yields and reduces or avoid investment in stocks if the yield is lower than bond yields (e.g., 10 year) and vice versa. Investing in stocks if the yields are lower than bonds creates a portfolio with high risk without the associated return. Investors can benefit by not investing in stocks when they are overvalued in comparison to bonds.
As seen in Table 1 the performance of portfolios D & E using these strategies is more predictable in different periods (e.g., 2004 versus 2009) and allows increasing the portfolio returns without subjecting to high risks. The two strategies require few data points, namely preferred asset mix based on retirement age, bond yields, stock PE ratios and dividend yields. These attributes are readily available and can be used to establish portfolio direction. There are other market timing approaches although they require significant time and know–how to produce predictable results and are best left to experts.
Investors can benefit significantly by periodic investments into diversified portfolios but more importantly by following market timing strategies such as portfolio re-balancing and/or yield comparison. A completely passive approach to investing and over reliance on a long time horizon can result in unpleasant surprises in portfolio performance. Investor needs to devise market timing strategy based on their individual goals and objectives
Every new investor to the stock market or new 401(k) plan participant is shown a chart that espouses the virtues of dollar cost averaging. So what is dollar cost averaging or DCA? DCA is when you commit to invest a certain dollar amount or percentage of salary to an investment program, usually in a mutual fund or exchange traded fund (ETF), over a consistent period of time.
For example, you are eligible to participate in your company’s retirement plan and you commit to invest 6% of every paycheck into a mutual fund of ETF that invests in equities. The standard DCA pitch goes like this and let me reiterate, is best suited for mutual fund investing or exchange traded fund (ETF) investing with firms like Charles Schwab that have commission free access for their clients. What if you were to invest $100 per period into a mutual fund of ETF that initially declines and then rises? The importance of the last sentence is because new investors are always cautious and they want to know what if my investment goes down initially. The example that is always illustrated is meant to appease new investor fears. The math is simple. If you assume that the initial purchase price of the fund or ETF is $10/share and that it goes down to $5/share before it goes back up then it looks like magic. The reason is because you are buying more shares at lower prices. What they never illustrate is the reverse. What if the price goes up and then comes back down? Table 1 below is the only illustration that most people see and it shows what happens when a person invests $100 for 11 months and the price goes down then comes back up. Table 2 shows the opposite price movement, which is just as likely to happen. This is happening every day in every retirement plan. It is happening to you so understand it.
(Price goes down and then up)
(Price goes up and then down)
As the two tables above clearly demonstrate the initial price direction from the day a person starts their dollar cost averaging program has a substantial effect on the short-term results of their portfolio. In both cases they invested $1,100 over 11 periods and in both cases the initial price was at $10 and the final price was at $10. So how can there be such divergent outcomes? In the first case, or Table 1 the investor has $1,491 after 11 months yet in the second case, or Table 2 they only have $912. The results from Table 2 are hardly satisfactory and might cause people to abandon a savings program such as DCA because they feel that it doesn’t work.
Let’s take it a step further and combine Tables 1 and 2 in such a way as to stretch the investment period from 11 to 21. In Table 3 we show what happens when the price goes down, then up and then back down. In Table 4 we show what happens when the price goes up, then down and then back up. Table 3
(Price goes down, then up, then down)
(Price goes up, then down, then up)
What can we learn from examining tables 3 and 4?
1) After 21 periods the portfolios are worth the identical amount of $2,303.
2) How each portfolio got to its final destination after 21 periods is completely different. In Table 3 we can see that after 16 periods the portfolio was worth $2,821 but only $829 after 16 periods in Table 4. Yet 5 periods later they are worth the same.
3) Years of observing human behavior tells me that at period 16 the person that had invested $1,600 over the last 16 periods and now only has $829 is more likely to abandon DCA than the person that has invested $1,600 and now has $2,821.
This is why over the years I have heard so many people say things like DCA doesn’t work. They are right from their point of view. See A Party Tale for a better explanation. It didn’t work because they abandon it at just the point where it’s likely to start producing positive returns. As in all behavioral tales we once again learn that the investor is an integral component of their return and not just the movement of the portfolio they own. Once again we learn that timing is everything. There is an emerging financial discipline or art form that speaks to this behavioral finance issue in a complex manner. The above illustrations speak to it in a simplistic fashion. I encourage you to look at tables 3 and 4 closely and ask yourself how you would react at any point in time. Pay particular attention to how you would feel, behave or react at the end of month 16.
Please don’t get me wrong, I like DCA but not for the same reasons as most advisors. I like it because if a lame illustration can encourage someone to invest in the stock market and this gets them on their way to higher lifetime rates of return and a higher standard of living, then it must be good. By hook or by crook if it serves the investor then I think a general good is being served. More importantly, a person that is introduced to DCA develops the habit of saving money. The subtitle of this tale is "It’s About Saving Money" because no matter what technique you use to invest, or the timing of your investment or whatever crazy notion crosses your mind, if you don’t save money you won’t have any. Remember that you must always put first things first. DCA serves one purpose and one purpose only and that is to show the novice investor that if they get in at the wrong time that it’s actually good for them. This is encouraging, helps overcome initial trepidation about stock market investing and subliminally educates people about the volatility of the market. It lets them start to develop the discipline of losing money should they start at the wrong time and teaches them to stay with a successful investment strategy. This is the real benefit of DCA. Unfortunately, as we learn in A Tale of Two Titans, the asset allocation decision dwarfs the DCA decision in terms of importance and too often the lessons learned from DCA only come back to bite you later as you accumulate more money in your account.
We learned in this tale that DCA is an effective savings vehicle for a person that wants to build a portfolio. We also learned that it’s important to start at the right time or else human nature can cause you to abandon your savings plan when you don’t get the results you expected. We also learned that if you stick with it long enough you will get a satisfactory result. A Tale of Two Titans will give you better insight about how you can resolve the timing problem so that you can build a sustainable and growing portfolio.