Does dollar cost averaging really work better in a volatile equity market?

Say that your equity market outlook assumes that one of two scenarios is true.  Either:

1. You expect equity markets to be volatile over the next 10 years or,
2. You are convinced that neither you nor anyone else knows what equity markets are going to do over the next 10 years!

but you still expect equities to outperform other asset classes over this term.

In this kind of environment a program of drip-feeding funds into the market makes sense as most research seems to suggest that market timers usually do worse than a more unemotional dollar cost averaging process. 

What is dollar cost averaging?

Dollar cost averaging refers to the process of investing the same amount to some regular timescale. When the price of the equities is low you will acquire more, and when high you will acquire less.

It may seem obvious, but is still worth stating, that dollar cost averaging essentially delays investing, which means that broadly as prices tend to rise over time this may reduce your returns…

Dollar cost averaging however itself has two problems aside from the implied delay element:

1. There are transaction costs
2. Can it be automated?

Transaction costs of dollar cost averaging

Ostensibly the transaction costs do not seem that high. You can download a very simple Excel model where you can put your own portofolio figures in here: Dollar cost averaging share purchases transaction costs.  

On the basis of $150k portofolio spread out over 10 sectors asset allocation sectors, with 10 trades per sector (100 trades in all), at $32 per trade (eTrade’s costs in Australia to private investors) you are looking at a transaction cost of around 2.13% on the whole portfolio using a dollar cost averaging strategy in establishing your portfolio:

Can you fully automate dollar cost averaging?

In an ideal world many time-poor private investors would prefer to set up a plan in advance e.g. ‘complete my dollar cost averaging plan over the next 2 years’, for example.  

This raises the question of whether share purchase orders set ‘at market’  or ‘at best’ can be poorly priced, whether deliberately or accidentally by the broker?

The short answer is the jury is out …. there didn’t appear to be any easily identifiable research and presumably it differs on a broker by broker basis.

However a common-sense approach might suggest that low liquidity shares with bigger bid/ask spreads might be more at risk of mispricing than broadly traded shares or ETFs.   

Know better? Comment below.

Posted under investment strategies, market timing

Having recently lived through the most dramatic trading week in living memory, it seemed like a good time to revisit the impact on long term performance of trying to time the market. Looking at the long term performance of the main investment indices of both the US and the UK stock markets produce similar conclusions.

The compound average annual return of the FTSE from June 1986 to June 2008 was 10%. If you missed the 10 worst days during this 22 year period, your annual compound return would have risen to 13%. A study of the S&P 500 from 1979 to 2004 shows an even more dramatic impact. If you missed the worst 10 days investing the in S&P 500 during this 25 year period, your annual compound return would have risen from10% to 38%!

If you were wise enough to look around you during the last couple of years and realise that booming global economic growth based on the apparently infinitely deep pockets of US consumers was unsustainable, congratulations! Perhaps you were even clever enough to reduce your exposure to sky high asset valuations in both property and equities. In which case you are already well on the way to achieving a much better return than those who believed the party would last forever!

But… even if you believe as I do, that we are at the beginning of a nasty global recession which may last 3-5 years, and which will see substantial rises in unemployment and slowing economic growth from Los Angeles to Beijing, it does not pay to wait for the young green shoots of economic growth to emerge before reinvesting in the equity market.

If you missed the 10 best days of the FTSE during the 22 year period from 1986 to 2008, your annual compound return would have fallen from 9.8% to 7.4%. If you missed the 10 best days of the S&P 500 during the 25 year period from 1979 to 2004, your annualized return would have fallen from +10% to -10%.

Cleary these are idealistic scenarios and nobody gets it right all the time, but given that Thursday 18th September was one of the worst market days in living memory, it’s probably fair to assume it will turn out to be one of the ten worst days this decade. For those brave or crazy enough to buy as the lemmings jumped, Friday 19th September turned out to be one of the best market days in living memory! The FTSE 100 closed up 8.8% – the biggest daily gain in its 24 year history.

Yes, the global crackdown on short sellers was no doubt a catalyst, and the $700 billion dollar promised “temporary asset relief programme” bailout by US Treasury Secretary Paulson had a dramatic impact on short term sentiment. Nevertheless I’m willing to bet that starting to buy on the dips will turn out to be a great long term strategy.

It usually pays to be contrarian. Global markets are likely to fall further and will bounce along the bottom for some time. But with global valuations some 25% below where they were a year ago, the risks have subtly shifted so that there’s probably now more to lose by being out of market than being in!

Posted under market timing