The Magic of Dollar Cost Averaging

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The Magic of Dollar Cost Averaging

• Portfolio Management

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K. Hartviksen
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Dollar-Cost Averaging

• This is a simple investment strategy that is
  designed to improve the rate of return an
  investor will realize on a portfolio over the
  long term.
• It is a strategy that can be used by any one
  however, it may have particular appeal to the
  smaller investor.

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K. Hartviksen
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Investment Selection

• As in any investment strategy, due diligence in
  the process of selecting an investment with good
  prospects is important.
• This is true whether the investment is a single
  common stock or the units in a particular mutual
  fund.

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How it is accomplished ?

• Invest the same amount each month in the
  investment of your choice.
• Over the long-term, the cost-base of your
  investment fund will change. This will enhance
  your prospects for a favourable return on that
  investment.

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Example - Side-ways Market

• Assume you invest 1,000 a month for 6 months in
  a market where the price of the stock is going up
  and down in the short term but essentially
  remaining unchanged (ie. going sideways)

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Example 1 ...
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Example 2 - A volatile market

• By chance, as you invest, if you are buying at a
  time of market weakness, the cost base of your
  shares can decline.
• Even if the ending share price in the period ends
  up being the same as where you started, you can
  earn a return because the average cost base of
  your shares has been reduced.

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Example 2 ...
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Example 3 - In a rising market

• Obviously, in a rising market you will experience
  returns.
• The returns would have been greatest if you put
  the 6,000 in at the beginningbut for many
  investors, the initial investment cash is not
  available.

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Example 3 ...
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Example 4 - In a falling market

• Obviously, in a falling market you will
  experience losses.
• Notice that the cost base of your shares is
  declining over time as you add more shares to the
  portfolio at progressively lower prices.
• A small increase in share price will now earn you
  a positive return.

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Example 4 ...
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Example 5 - In a falling market

• A small increase in share price will now earn you
  a positive return.

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Example 5 ...
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Example 6 - Buying on Market Weakness

• Strategically buying shares when market prices
  soften can yield very positive results
• The lower the market price, the more you buy!
  The higher return when the market price returns
  to where it started.
• YOU MUST BE CONVINCED OF THE INVESTMENT MERITS OF
  THE STOCK OR MUTUAL BEFORE YOU BEGIN!!

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Example 6
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Important Terms

• DCA refers to dollar cost averaging it is a
  systematic investment strategy in which a fixed
  dollar amount is invested on a regular basis in a
  particular stock or mutual fund.
• GIC guaranteed investment certificate is a
  financial product sold by most deposit-taking
  financial institutions to retail customers
  offering a fixed rate of return on a guaranteed
  principal provided that the investor lock-in
  their invested capital for a fixed period of
  time, like 1, 2,3,4, or 5 years.
• Average cost base - the average price paid for a
  given type of financial security. In dollar cost
  averaging, the objective is to see that cost base
  decline as more similar securities are purchased,
  through the purchase of cheaper securities. The
  cost base is equal to the weighted average price
  of all of like securities in the portfolio.

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Key Focus

• That DCA strategy is a bearish bet on the market.
• That DCA is inefficient in that you should either
  not have invested in such an asset assuming it
  would decline in price, or if you feel it is a
  good investment, then an efficient strategy would
  be to invest the total amount right now.
• DCA is a market timing strategy, but modern
  financial theory argues that in an efficient
  market where prices quickly and accurately
  reflect all relevant information, there is no way
  to use market timing to beat the market.

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Underlying Research and Statistics

• Milevsky and Posner, A Continuous-Time Analysis
  of the Risks and Rewards from Dollar-Cost
  Averaging, International Journal of Theoretical
  and Applied Finance, World Scientific Publishing,
  2003.

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Research Findings

• The research shows that DCA is inefficient in
  that you can generate the same expected return as
  a DCA strategy, but at a lower risk (as measured
  by standard deviation) by splitting your money
  roughly in half one part going into an equity
  fund, the other going into a GIC

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Conclusions Lessons to be Learned

• Replacing one major investment decision with many
  smaller ones does not make the final outcome any
  safer.
• DCA may be a good saving strategybut it is a
  poor investment strategy.