In my previous article, I showed that using a simple dollar cost average (DCA) technique worked at least as well, if not better, than a timing technique based on the Percentage Above Average Yield (PAAY). But this test was based on looking at one stock at a time. That is great if your entire retirement account is invested in McDonald's (NYSE:MCD) or Procter & Gamble (NYSE:PG) or any other individual stock, but most of us look for diversification and have multiple stocks in our accounts. So I thought it would be useful to see how PAAY could be used to increase returns in an entire portfolio, rather than on any one individual stock.
We already know that DCA is an effective method for long-term investing. Every quarter, when you get your pension contribution, you immediately invest it in the stocks you already own, or in new stocks. My question is should you just buy equal dollar amounts of each of the stocks you own? Should you always balance how the money is allocated? Or could your returns be improved if you used valuation to decide how to allocate the new funds? I ran a back test to see.
For the tests, I used the same ten stocks I used in my previous article. Aflac (NYSE:AFL), Air Products (NYSE:APD), Boeing (NYSE:BA), Deere (NYSE:DE), Emerson Electric (NYSE:EMR), Johnson & Johnson (NYSE:JNJ), McDonald's, Procter & Gamble, Target (NYSE:TGT), and United Technologies (NYSE:UTX). In both cases, starting in January 1990, I assumed a $1,000 pension contribution every quarter up until present day. For the DCA test, I assumed that the contribution was divided evenly between the ten stocks in the study and the appropriate amount of shares were bought. For the valuation study, I used the entire $1,000 to buy only the one stock which, at the time, had the best valuation based on its PAAY. I also compared these to a portfolio that simply invested in the Vanguard S&P 500 index fund (VFINX). Over the course of the entire back test, a total of $91,000 would have been invested in each portfolio. The results are as follows:
Final valuation of the portfolio:
DCA - $430,765
PAAY - $498,013
VFINX - $218,541
Both stock portfolios handily beat the S&P 500 index fund, once again showing that a DGI portfolio can beat the market over time.
Here is the final composition of each of the two stock portfolios
The results show that by buying only the most undervalued stocks based on PAAY, each time you receive a contribution into your retirement account, your returns will improve significantly. It is also interesting to note that your portfolio will become very unbalanced over time. As you can see, many more shares of AFL, DE and TGT were bought over the years in the PAAY account as compared to the DCA account because many times during the test period they were the most undervalued stocks. Conversely, relatively few shares of APD, EMR and PG were bought because they were usually fairly valued, if not overvalued, as compared to the other stocks in the portfolio. If you are one who likes to keep your positions balanced in your portfolio, this method will probably not work for you.
I have other valuation methods to study, but I believe I have shown that at least one measure of valuation, PAAY, can be used to improve returns over a straight DCA method of investing.