For centuries, (well, decades at least) investors have hopelessly tried to determine when the right time is to buy variable investments. Looking at the past, it is easy to see when a good time to buy was, but it is not so clear when a good time to buy is. There are economic indicators that tell us when the time is right to buy stock, but in reality, most indicators are not all that reliable. Often when we make a major investment based on an important indicator, for example, Baron’s Confidence Index, we find out later that if we waited another six months or so, it would have been a much better return. It seams that for some reason or another, the indicator was temporarily out of sync. This is not to suggest that any gauge is not worth studying, only that they are best when looking to the past, not into the future.
If we can’t count on any measure of the market to tell us when to invest, how do we decide when we should we take the plunge? The easiest answer is to invest continuously. Don’t even try to time the market. Only those with some special insight of which the rest of us are bereft should use market timing as an investment policy. Sure, maybe we can recognize extreme situations, and should act upon them, but too much timing usually causes too many errors. An Investment portfolio is like horse crap, the more you move it the more it stinks.
There are always more complex methods to accomplish a particular investment objective, but sometimes the best formula is the easiest.
DOLLAR COST AVERAGING
To solve the timing problem, dollar cost averaging was devised. This is a method of investing the same amount of money at specific regular intervals into a variable investment, normally a stock or mutual fund. As the share value of the investment increases, the DCA’er purchases fewer shares. As the per share value falls, more shares are acquired.
Most DCA’ers arrange for their bank to automatically wire their investment to the fund of choice. This is much less labor intensive than writing a check every month. We need to remember to deduct the amount from our account balance. It is very easy to get started and keep going from an automatic pre-authorized checking (PAC) plan.
EXAMPLE: Assume that Mutual Fund X has been selected for a dollar cost averaging program. The investment is expected be $100 per month for at least 10 years. The fund cost is $10 per share at the beginning, so 10 shares are initially bought. Assuming that the amount of monthly investment is not changed, exactly 10 shares may never again be bought during that period.
Suppose Fund X stays at around $10 dollars per share for a few months, then it begins to decline. There is a very bad market and in two years the fund is down to $7 per share. Still the investment is $100 every month, but now 14.29 shares instead of 10 are acquired. The shares bought each month are worth $100 at the time of purchase, but more shares are accumulated when the share price falls.
Another two years go by and the fund rebounds to $10 per share again, and again about 10 shares per month are accumulating. The shares bought with the hundred dollars when the price was $7.00 are now worth $142.90, because automatically more were acquired. After four years, the price of the fund is the same as it was originally, but profited has been earned from the fluctuation.
Assume that the next two years the market is strong and Fund X increases in value to $15 per share. As the investment continues the number of shares bought now decreases to 6.67. When the price is high, fewer shares are automatically bought.
Because we really don’t know how high high is, we do not stop buying. The price may appear to be high, but it could go much higher. The dollar cost averaging method does not help us to know when to sell, but automatically forces us to buy fewer shares when the share price is high, and more when the price is lower. One thing we probably have in common with the vast majority of very highly paid and knowledgeable investment managers is that we don’t know exactly when the market tops out. When we use dollar cost averaging, we don’t have to know. It is not part of the formula for success.
Some systematically invest into United States Savings Bonds or their local bank through payroll deduction, in essence much like dollar cost averaging. The idea is to accumulate substantial amounts of money over a long period of time, a noble cause indeed. There is a big difference between these investments that do not fluctuate in share value and those that do. When investing regularly, the fluctuating investment is advantageous over a period of time due to the variable prices. Those shares bought low provide much of the gain. A bank account or a bond can’t offer that. All shares are bought at the same price, the only difference is the rate of return.
Clearly dollar cost averaging is better suited for investment in a mutual fund that fluctuates rather than a consistent savings type of vehicle which does not. That now begs the question: “Are there funds that should be selected over others for this purpose?”. Given the same long term return expectation, does it matter which fund we choose? Yes. We arrive at this conclusion through simple logic. If the advantage a fund has over a savings bond is due to its level of volatility, then given similar long term results, a more volatile fund is more suitable for dollar cost averaging investment than a more consistent performer.
Be careful not to select a highly volatile smaller sector type fund because the sector may become permanently out of favor, the share value never coming back to its original price. Look for a large well diversified aggressive global fund. A long lag on the low end of the performance chart will return a favorable result eventually. This is actually an even better scenario. Think of it this way, the longer shares can be acquired inexpensively, the more that will be valuable later.
A dollar cost averaging program should not be started unless there is a reasonable certainty that it can be maintained over a number of years, preferably 10 or more, but at least five. By investing for a year or two we risk the possibility of only buying into a rising market. The result will be that shares have been accumulated at a high price. Over a longer time it will eventually work itself out. If there is reasonable expectation that the program won’t continue for at least several years, don't start. If it can’t be continued, cash reserve is probably limited. This leads to the conclusion that there is a real likelihood that a redemption may soon be necessary and very possibly at a lower price than the share cost.
TAX DEFERRED MONEY
A tax deferred situation is ideal for dollar cost averaging. A qualified retirement plan (IRA, Keogh, 401(k), SEPP, etc.) is great because we can invest regularly with an eye towards locking in gain if an opportunity presents itself. Lets say for example that we’ve invested faithfully every month for 12 years and now the market appears to be fairly high. We recognize this high point because it has increased 40% for two years in a row. Because many of these shares were accumulated when the market was lower, we may wish to lock in some profit.
Here is the idea: We remove a sum from the stock, there is no tax because it is tax deferred in the retirement plan. Place it into a cash position in the fund’s money market or short term government securities fund. Now investment should continue monthly into the same aggressive fund as always with new contributions. The market still may go up. With the cash account now, we can arrange for that money to be placed back into the aggressive fund over a period of years (five to seven or so) on a monthly or quarterly basis. This is in effect re-dollar cost averaging with the already successful money. Recycling money.
If the market does fall as expected, another opportunity (low point) should be anticipated for placing the rest of the money back into the aggressive fund. Lets say for example that when transferred to cash, the aggressive fund was $20 per share. As the share value drops to $16, we may decide to put it all back in again. We have shielded ourselves from that $4 price decline, earning money market rates during that period. If the fund continues to drop temporarily say to $12 where it bottoms out and begins to rise again, still we did better than leaving it in when clearly the potential for loss far outweighed the possibility of additional gain.
Too many moves of this nature are not recommended. Constant changes can be counter-productive. When there is extreme confidence that the investment has done very well and preserving some gains becomes more important, it is not necessarily a bad idea. A further suggestion might be to wait for a 5 or 10% decline before authorizing a transfer, then waiting for a 5% increase before reentering the aggressive fund with the lump sum.
Keep in mind that all timing techniques involve risk. Dollar cost averaging is intended to avoid such risk. We are just adding a little aggressiveness to try to maintain profits, not to actively move in and out of funds. Be careful, if moves are made more than a couple of times a decade, it probably is too often.
It is not necessary to be inclined to actively move investments. Dollar cost averaging as described above should be fine without any planned transfers. This is simply accumulating shares and holding. Much like the “Buy and Hold” strategy, the “Accumulate and Hold” should work very well if employed for a long enough period of time.
Dollar cost averaging is an effective method for accumulating money in a fluctuating asset, for some though, it is too boring. Some feel it is too much like watching a dog sleep, terribly dull. For the more active, there is a strategy which magnifies the effectiveness of Dollar cost averaging, it is called Value averaging.
Value averaging is a mathematical formula based on the targeting of an accumulation goal usually on a monthly basis. Here’s how it works. Rather than investing say $100 per month into a mutual fund, instead an accumulation goal is set to increase by $100 per month. After month one the total value should be $100, after month two it should be $200, and so on.
The first month $100 is invested. Lets assume that the price stays the same for a month. In order to bring the account balance to $200 in month two, another $100 is necessary, so a deposit $100 is made into the fund again. Now month three comes along and the share price drops. The account value is not $200 anymore, but $180. Remember the target is $300 after month three so now need the deposit has to be $120 to reach that figure. Even more shares are bought now that the price dropped than under dollar cost averaging which would have required only another $100 investment.
Now the fund remains fairly stagnant for another two months so we deposit our $100 each month again. But the sixth month we see an increase in price. Instead of a value of $500, the fund share price has increased and the account is worth $525. In order to bring the value to $600, we need only purchase $75 worth of the fund because the price is higher. So, on the higher end of the share price scale value averaging compels us to buy even fewer shares than dollar cost averaging.
At the end of one year, there should be $1,200 in value in the account ($100 for each of 12 months). The total investment may have been more or less than that. The next year we may keep the same accumulation goal, but eventually we will have to change it. As the account grows over the years, dividends and capital gains increase and are paid regularly. This will reduce the out of pocket contribution to the fund. If it increases to the point that its value grows an average of $100 per month, (not all that unlikely over time) no more contributions would be necessary if we do not change the target. We need to periodically increase our accumulation targets or the investment contributions would stop because we will eventually have reached every target with fund distributions alone.
If the fund payouts increase to an average of $100 per month in earnings, we may want to raise our accumulation target to $200 per month, requiring a contribution of about $100 out of pocket each period. Of course when the value drops, larger contributions would be required, larger even than the $200. We assume that since we had months in which we made small or no investments (which lead to our increase of our accumulation target) money accumulated in cash will enable us to make the now larger investment required under the new target.
An ability to continue the program over several to many years is even more critical with value averaging than with dollar cost averaging. There will be periods of market decline where larger monthly investments will be necessary. We don’t know if market declines may come early in the program or years later. Regardless of when the need for greater contributions arise, the investor must have the resources to continue through these periods of falling prices. This is where the largest profits originate, the main thrust behind the value averaging concept.
Like dollar cost averaging, value averaging works best when more volatile investments are used. Personal temperament should be kept in perspective. The investor must know himself well enough to realize whether or not he can live with the inevitable volatility.
Value averaging is a very active investment strategy. It magnifies the mathematical effect of dollar cost averaging, but requires constant monitoring. For some this is too demanding a program. We can’t generally pre-authorize withdrawals from bank accounts because we don’t know the exact amount until the investment date. We usually have to physically write the check or call the fund to arrange for the transfer.
Of those who’ve examined the benefits of value averaging, many still prefer dollar cost averaging as an accumulation method simply because it is automatic and low maintenance. Our time is worth something, and there is much to be said for simplicity in life.
Value Averaging offers a greater benefit from periodic investment. Dollar cost averaging is a little less effective but much less labor intensive. Now we have a choice.