Friday, September 14, 2007

Dollar Cost Averaging

Here is a financial planning tidbit to think about over the weekend - dollar cost averaging into an investment portfolio. Dollar cost averaging is an ideal method to build portfolios over time.

What is it?
Rather than make a lump sum investment purchase, dollar cost averaging involves the regular purchase of a small amount of an investment on a weekly, monthly, or quarterly basis.

Why does it work?
The theory is that, over time, financial markets fluctuate, and a fixed dollar amount will yield varying units of a security - such as a mutual fund. The result is that more of the security will be purchased when prices are low, while less of the security will be purchased when prices are high.

What are the advantages?
Three important advantages of dollar cost averaging are:
a) minimizing market timing concerns
b) eliminating concerns over investing possibly large lump sum amounts, and
c) disciplined savings.

How can you do it?
The strategy can be implemented easily by setting up a systematic investment plan that transfers funds from your bank account into your investment account on a regular basis.

An example involving an initial investment of $1,000 in the CI Portfolio Series Balanced Portfolio starting in November 1988 and subsequent contributions of $200 per month until August 2007. This modest start and contribution schedule would have resulted in a $104,000 portfolio value today. This method is quite conservative and the returns far outstripped inflation, Canada Savings Bonds, and 5 Year GIC returns.
I like dollar cost averaging because it eliminates a lot of the emotion from investment decisions and is very disciplined. Have a great weekend.

22 comments:

rentah said...

It does work.

I don't use it, though, because I'm a contrarian. A contrarian tries not to eliminate the emotion from investing, but rather uses emotion as a meter: A contrarian does the OPPOSITE of what their emotion tells them to do. They buy when they are fearful, and sell when they are ebullient. Pretty freaky, eh?

mohican said...

rentah - I do both dollar cost averaging and contrarian or value investing.

I dollar cost average into my retirement plan and I invest lump sums when I find value in the market or when a contrary situation comes up.

Both have worked extremely well for me and I don't plan on changing a thing.

freako said...

I agree with and appreciate all your posts related to personal finance, but I would have to disagree with this one. I think "dollar cost averaging" is bullshit and totally abused by the sell side such as commissioned mutual fund salesmen.

Van Housing Blogger said...

I'm afraid I'm with the other dissenters.

Debunking DCA is nicely done on this wikipedia post here.

Here is an MSN article.

Here (PDF) is the underlying academic research.

I'm sympathetic to the idea that making a regular contribution is easier psychologically in that you can set it up and you don't have to think about it anymore. That is, you are more likely to save more if you 'pay yourself first' as the saying goes. But that is an argument about the total amount invested, not the rate of return.

Here's the final word from the wiki entry:

"Dollar cost averaging has been widely criticized by economists and academic finance researchers as more of an marketing gimmick than a sound investment strategy (a way to gradually ease worried investors into a market, investing more over time than they might otherwise be willing to do all at once). Numerous studies of real market performance, models, and theoretical analysis of the strategy have shown that in addition to having the admitted lower overall returns, DCA does not even meaningfully reduce risk when compared to other strategies, even including a completely random investment strategy."

Van Housing Blogger said...

That aside, I love the work you're doing with the data and the graphs, Mohican!!!!

mohican said...

Thanks for the kind words VHB - nice to hear from you.

I have heard the dissenting view on DCA before - as you and freako have pointed out. I recognize the flaw in the argument for the strategy on an 'investment returns' basis. The argument I would put forward to contrast is this:

1) Based on acedemic research - DCA offers typically lower investment returns than other strategies
2) DCA is not so much about maximizing investment returns but rather about an unemotional and disciplined approach to, most importantly, saving and lastly, investing
3) Most people when left to their own devices regarding choosing how much to save, what to invest in and when to invest make the absolute wrong decisions. We are the minority who read this blog.

If I do a financial plan for someone and the result of this plan is that the client must save $500 per month for the next 10 years and earn a 7% rate of return in order to reach their goal it makes absolute sense to dollar cost average for two reasons.
1) Easy implementation - this is important for me and for my client
2) Disciplined - the client is not faced with the temptation of spending while seeing a large bank balance accumulating waiting to invest.
3) Unemotional - when markets are down it is the best time to invest although most people will do the opposite. Market timing for most people hurts rather than helps their rate of return. There are many studies that back this up.

This study is particularly interesting.

solipsist said...

Some things that I wonder quite a bit about are;

there is consensus (isn't there?) that markets of all flavours are "over-valued" at present, and we saw some shaking out of TSX, DOW, etc. a few weeks ago, but the TSX is heading back to 14,000, oil closed over $80 Bbl yesterday and gas prices are down today, the housing market smells like it's teetering on the brink, there seems to be a core of thinkers talking recession - even depression, David Dodge muses in London, England that he should have increased interest rates last round (but not by what magnitude), CAN $ headed for parity or better, and on and on. So what to do? GICs linked to prime? linked to the TSX? (i wish I had been more "reckless" with my nut last year).

I'm very judicious with my larger savings, but do make inspired investments with my more "disposable" income - of which I lose some and win some, and probably have broken even over the last 10 years.

What could one do beyond cashable GICs to make a better return than on same, but still be 99.9% "safe"?

I'm also curious about just what a financial planner is, do they work on contingency, commission, or hourly, etc.

Please excuse my loquaciousness, it's the after-work beers...

freako said...

DCA is not so much about maximizing investment returns but rather about an unemotional and disciplined approach to, most importantly, saving and lastly, investing

Yes that is true, and if you had merely called it something like "forced monthly savings", all would be hunky dory. But I don't like the idea that you are better off because you buy more when it is cheap and less when expensive. This appeals to commons sense, but the line of reasoning is flawed. And that is why I think it is abused by the commissioned mutual fund salesmen. They want people to go on monthly plan because that is one way of hooking people into long term relationship that gives on giving commission cheque after commission cheque. DCA is the perfect pitch to hook people.

If I do a financial plan for someone and the result of this plan is that the client must save $500 per month for the next 10 years and earn a 7% rate of return

You do this for a living, and I am not going to tell you how to do your job, but I don't view things from that perspective. And I am not saying that mine is better, just that it makes more sense to me, so please don't take offense.

I would start with what people have (current income, assets) rather than what they want. Then I would allocate that into an optimal portfolio that takes into account risk preferences.

Not really sure why, but I don't really like the angle of asking people where they WANT to end up. Rather, I'd find out where they are, and I will tell them where they can go.

I think that wanting a given lifestyle is what cause people to take on excess risk (I NEED two million dollars at retirement, so I will do whatever it takes to get there). Your risk tolerance should tell you what you can get, your needs shouldn't tell you your risk tolerance.

freako said...

there is consensus (isn't there?) that markets of all flavours are "over-valued" at present,

Not exactly. The market IS consensus. If the TSX goes up, that is because market consensus felt it deserved to.

Markets do go in and out of efficiency, but there is no such thing as universal agreement that a market is overvalued. Of course, once a bubble has popped everyone will say that they knew it was going to happen, but their actions at the time say otherwise.

GICs linked to prime? linked to the TSX? (i wish I had been more "reckless" with my nut last year).


There is no free lunch. Those are a bit gimicky, and merely a hybrid of TSX options and GIC's. You could roll your own if you prefer, you'd probably need a sizeable amount to make it cost effective.

What could one do beyond cashable GICs to make a better return than on same, but still be 99.9% "safe"?

Unfortunately risk/return still holds. If you wanted your life to be simple, merely invest in a diversified equities fund and keep it there through thick and thin. The upward bias is strong enough that there is little reason to be cute and time the market. RE is another matter, and staying out can be incredibly financially rewarding. Though I have no idea why this bubble simply won't die so we can be done with it.

patriotz said...

I think the question begs asking - if you are investing a regular amount each period, then what is better than dollar cost averaging?

If you're saying DCA is not optimal, that means you think you can do better by timing the market, i.e. staying in cash until you find the right opportunity, rather than buying, or by choosing securities to buy each month based on how well you think they will do going forward. But this is exactly what mutual fund managers do - try to outguess the market.

Well of course investors in aggregate cannot beat the market, which is why index funds do better than managed funds (in aggregate). If the mutual fund managers can't outperform the index, how can J6P be expected to by actively managing his own portfolio, or by hiring some "expert" to do it (at a cost of course).

I really don't think there is anything better for the average RRSP investor than dollar-cost averaging into low cost index funds or ETF's. If you do, let's hear it.

On the non-registered side, I do my own stock picking, as there are tax benefits for dividend income, and as well I can get some tax mileage from managing capital gains/losses. But inside the RRSP I don't.

freako said...

If you're saying DCA is not optimal, that means you think you can do better by timing the market, i.e staying in cash until you find the right opportunity, rather than buying, or by choosing securities to buy each month based on how well

No. What those studies are saying is that you invest what you have to invest when you get it. A lot of times that may coincide with a DCA investment schedule, but that is besides the point, and does not make the logic behind DCA correct.

But if you are say a commissioned sales person where income can irregularly and in lump sum sizes, DCA makes no sense at all.

Basically you invest what you can spare based on your income, no matter when it is received.

I really don't think there is anything better for the average RRSP investor than dollar-cost averaging into low cost index funds or ETF's. If you do, let's hear it.

You are twisting a little here. If I say that DCA is suboptimal, you assume that I then recommend market timing monthly investments. Not true. They should make regular monthly investments, but don't call it DCA, call it "regular monthly investments schedule" or something, and trumpet the benefits of doing so. And it isn't DCA. That is a gimmick.

freako said...

The result is that more of the security will be purchased when prices are low, while less of the security will be purchased when prices are high.

This is the part that I have a problem with. While not untrue, it implies that there is some tangible benefit to this where you "buy low and sell high". In other words, it implies that are just like Warren Buffett but without having to do any thinking and that you will end up a head of an investor who didn't use this clever trick. This is untrue and gimmicky.

jesse said...

"if you are investing a regular amount each period, then what is better than dollar cost averaging?"

DCA implies investing in one asset. I don't see the difference between doing DCA and "regular monthly payments", if they are put in a mutual fund or another portfolio that re-balances regularly.

DCA can also imply you have the full lump sum available today such that you could invest it all if you so choose. Some people don't have that option but want a certain amount of a particular asset so must do it over time. This is not really DCA because it is done out of necessity and not a strategy per se.

The thought experiment I use is as follows: I want to invest 10K in a stock that I think has great long-term growth potential. I can invest 1K per month for 10 months or invest 10K right away. If I invest 10K right away I run the risk (compared to DCA) that the stock will drop in value in the next 10 months, the inference being it will eventually increase in value from month 11 onwards until I sell it.

If the stock has great long-term potential it is, all things equal (and assuming it is difficult to time the market, which is a separate topic), statistically more likely to go up in value than down in the next 10 months so it's better to invest it all now.

If you are down to your final pull at the slots then you might want DCA.

Warren said...

Jesse why does DCA imply investing in one asset? I'm not sure how you are defining "asset", but I use DCA across a variety of mutual funds for my RRSP savings.

I also use an unregistered account to make regular investments in specific stocks.

Your experiment makes sense, but I don't think people are using DCA for stocks too often. Apart from a few DRIP/SPP stocks I own, I think long and hard before investing in a particular stock, then make a lump sum buy and ride it out. The issue is more about transaction costs for me.

I think throwing all your eggs into one basket like that $10k stock buy is a bigger slot pull than $1k per month for 10 months.

jesse said...

warren: true. If you do, say, ten 10K investments over a year you are spreading the risk anyways -- there's no point to DCA each of these 10K bets. I would argue it's best to have money in play earlier and DCA delays this.

That said, it's scary to throw everything you own in at once. Likely DCA produces subpar returns compared to other strategies but in the case where you only have one bet and one life it can make sense.

I think the distinction between risk management and DCA needs more attention.

Warren said...

Jesse,

If I can put my freako hat on, I'll say that DCA must mean lower gains because its lower risk, done and done. :)

talus said...

Waayyyy OT --

OT -

I read around a bit and stumbled on this bank run at the British Bank Northern Rock.
Google News Results

I also watched this 45 minute presentation on "Money as Debt". A Google video depicting how money is created through borrowing.
http://tinyurl.com/26meoq

Now what happens if no one borrows and/or those that have don't pay it back.

freako said...

If I can put my freako hat on, I'll say that DCA must mean lower gains because its lower risk, done and done. :)

Many issues here. Again, my beef is with the gimmicky nature of the claim of "averaging cost". I like the regular monthly payments aspect, but has nothing to do with the purported benefits of DCA.

As for lower risk and lower return, yes. Whether we are investing in one asset or many, DRIP's, RESP or stocks is all beside the point.

If I have say $12,000's, I can invest in my preferred risky vehivle (say an indexed mutual fund) as a lump sum, or I can invest $1,000 a month for a year. If I choose the latter, I put $11,000 in a high interest savings account. At the end of the year, I will have invested $12,000 in the stock, so what is the difference?

The difference is that with lumpsum, I have $12,000 in the market for a year. With DCA I had $1,000 for 12 months, $2,000 for 11 months, and so on. Rounding, average, I had $6,000 in the market for a year, or $12,000 in the market for 6 months (ignore compounding).

If the market is a random walk (and the logic behind DCA assumes that it is), the market have a given rate of upward bias, say 10%, and a risk factor.

Compared to a upfront lump sum, DCA offers a lower return at a lower risk. The million dollar question, however, is whether DCA offeres lower risk than a smaller lump sum with equivalent return.

For example, $12,000 lump sum invested six months in asset, and the next six in cash. The DCA argument implies a market beating self-regulating mechanism. The answer is no, no no.

Confusing stuff, perhaps an anology will help:

Gas prices vary a lot. There are two strategies:

1. Get $70 worth of gasoline once a week (lump sum). Big tank, I know.
2. Get $10 every day of the week.

Based on the DCA logic, the second option would be superior because you are buying more gas when prices are low. You can go ahead and try it if you want, but I hope the answer is clear, that you will not get a better average price, so the DCA logic is hogwash at best, and snake oil at worst.

patriotz said...

No. What those studies are saying is that you invest what you have to invest when you get it. A lot of times that may coincide with a DCA investment schedule

I think we really have the same point of view, but just some comfusion with terminology. When I say DCA I just mean J6P invests the same amount from his paycheque every month. Or more generally, buy when you have the money. Whether your purchases are regular amounts or more random, that will average your purchase price over market cycles. Hence DCA.

What J6P shouldn't do is try to time the market. This usually results in holding cash when the market is perceived to be falling, and ultimately a higher average purchase cost.

freako said...
This comment has been removed by the author.
freako said...

I think we really have the same point of view, but just some comfusion with terminology.

Seems that way. When academics knock DCA, they are not knocking regular monthly payments per see.

Cutting to the point, just curious, how do you view the gas fill up analogy? (reposted and reworded below) Do you buy the DCA logic, and if not, do you think a typical person would if presented to them?

Gas prices vary a lot. There are two strategies:

1. Get $70 worth of gasoline once a week (lump sum). Big tank, I know.
2. Get $10 every day of the week (DCA). The result is that more gas will be purchased when prices are low, while less gas will be purchased when prices are high.

Is strategy 2 superior as a result of the cost averaging?

freako said...

What J6P shouldn't do is try to time the market. This usually results in holding cash when the market is perceived to be falling, and ultimately a higher average purchase cost.

Well if J6P does a worse job than static investing, couldn't we do a better job than static by doing the opposite of what J6P does?