Carlos M. Sera's  Instablog

A Tale of Perspective

“It’s About Saving Money”

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.

(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.