Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Transaction Costs, Dollar Cost Averaging, And Investment Returns

Summary

Many investors are faced with choice of investing smaller amounts of money regularly versus larger investments less frequently.

Transaction costs can play a large role in the decision making process, as well as expected stock market movements and potentials dividends either received or forgone.

I give a framework for developing an investing strategy that seeks to analyze this trade-off.

I also provide a free web application for finding a custom strategy for your particular situation.

Introduction

A common dilemma faced by an investor can be summarized as follows:

  • The person steadily accumulates money, either from saving part of his regular income, dividends, rent checks, or any number of sources.
  • He wants to invest this money via purchasing individual securities (or bonds or derivative contracts) with a particular transaction cost, say $4.95 per trade.
  • Now, he wants to know if he should just invest the money as he acquires it or if he should make fewer trades with larger sums of money.

The trade-off of course is that investing regularly with smaller amounts of money starts the (hopefully positive) compounding process sooner. The downside is that more transactions often come at the price of a higher total transaction cost. The money spent on commission is gone forever and hence can seriously impair investment returns.

Important Considerations

While there are many factors that might affect this investment decision, I specifically consider:

(1) The monthly amounts to invest. For many people in the accumulation phase, it can be difficult to find enough room in the budget to set aside for investing. Hence, the monthly amount available for investments can be relatively small (don't mistake small investments for small results, however).

(2) The transaction costs. Brokerage firms tend to charge varying commissions. This can range from free to quite expensive depending on the amount of servicing demanded. Common commission charges for purchasing common stocks is about $5 a trade.

(3) General market movements. Generally speaking, if the market is moving up, purchasing more regularly with smaller amounts would be advantageous relative to larger, less frequent purchases due to capitalizing on more time in a bullish market. The opposite situation can easily occur, however, where fewer but larger purchases can be beneficial when faced with a more bearish scenario.

(4) Dividends. Simply put, you cannot collect dividends without investing. Money left accumulating in your brokerage account is money not generating dividends. In the current low interest rate environment, you would be lucky to earn (a heavily taxed) 1%.

Note that, though taxes would have a notable effect, I left them out of this discussion for simplicity.

A Helpful Tool

To address these and related questions, I wrote a freely available web application (*). This web application has three sections of inputs to allow for specific user customization. The first column of inputs allows for specifying the investor's monthly contribution along with transaction costs. The second column pertains to the expected market condition going forward. The user can input the number of months of expected negative returns, positive returns, and flat (neutral) returns, along with their severity and order. Lastly, in the third column, the user can adjust the dividend schedule. This entails choosing how often the dividend is issued, what is the dividend yield, and whether the investor plans on directly reinvesting dividends or if he plans on accumulating those dividends and investing them as if they were new capital.

So, for example, suppose an investor has $500 a month to invest and uses a brokerage that costs $7.95 per trade. He is expecting 6 negative months with returns of 0.9 (this would correspond to $1000 decreasing to $900 over a half of a year), followed by 18 positive months with returns 1.1 (hence, this $900 would increase to $990 over the course of a year and a half), followed by 12 months of neutral growth (the $990 remains unchanged). Lastly, this investor is expecting quarterly dividends with a 3% yield and he plans on directly reinvesting dividends. In this situation, a strategy of regularly investing $1,000 every other month would result in the best returns ($21,959.52 at the end of the 36 months). The second best strategy would be regularly investing $1,500 every third month ($21,917.89). The worst method would be investing $6000 annually ($20,819.69). Here is a screen shot of the web app results for this particular situation:

Perhaps this investor is instead planning on investing in Alphabet Inc. (NASDAQ:GOOGL), which does not issue a dividend. Hence, he would set the dividend yield to 0%, leaving everything else unchanged. Now, the strategy of investing $3000 every six months provides the best returns ($18544.37) while investing $500 monthly provides the worst ($18282.18).

Conclusion:

It is important to have a thorough understanding of the implications of transaction costs. While future market movements are of course a mystery, performing a sensitivity analysis on any investment strategies can help find potential weaknesses or even reveal faulty intuition. Therefore, the provided web application could be a valuable tool in an investors tool box.

(*) Using the R-project language and Shiny Apps. This application is free of charge. And though I have made a significant attempt at checking the application for error, the results come with no guarantees.

Disclosure: I am/we are long GOOGL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.