Episode 45: DCA: Market Volatility

In Episode 44, it seemed that Lump Sum investing is superior to Dollar Cost Averaging (DCA). One aspect was the ability to actively time asset and market fluctuations under a Lump Sum approach. However, DCA does help investors to smooth market volatility and better manage investment risk in their portfolios.

Smoothing market volatility versus actively timing fluctuations. Which is more prudent for investors?

All that and more in Episode 45 on the Wilson Wealth Management YouTube channel.

“In the long run, Lump Sum tends to outperform DCA. What about shorter time periods?”

That is a big problem with Lump Sum. Over short to medium time periods, there can be lengthy down markets or substantial price volatility. As we see in the video, short to medium may be 5-20 years before the markets recover to where they were post-crash.

Short given that the markets have been around for more than a century. But quite lengthy for the average investor if they invest 100% at a peak.

“Lump Sum may work in the longer term. But what about meeting my short term objectives?”

This is a related issue to the first point.

If you are 20-30 years old and your only investment objective is to accumulate wealth until retirement, you may have 40 plus years before beginning to draw down invested capital. That lengthy time frame allows younger investors to withstand market volatility, even if it is prolonged.

This is why younger investors tend to focus on higher risk (with higher return) assets.

But, even for younger investors, not all financial objectives have 40 year horizons. What about saving to buy a home in 3 years? Your child’s education in 10? Or, you are now in your late 50s and retirement needs may be 15 years away?

Had you bought into the Dow Jones Index in 1965, it would have taken until 1983 before it began to appreciate in value. With lots of volatility in that period.

The same is true in late 2008. Had you been fully invested back in 2000, all your gains would have been gone. And it would take until 2012 before recovering.

For those whose financial objectives matured in that time frame, they may not have experienced any positive returns.

“Why do professional asset managers not exploit short terms market peaks and troughs?”

That is the question.

We covered some of the data in “Episode 38: Investor Behaviour”. It is amazing how just a few days of missing market moves upwards can negatively impact portfolio growth. Even strong money managers will have difficulties exactly picking the “right” time to enter and exit markets.

Add in a variety of other factors. If you ever watch the “talking heads” on television. How often do they correctly predict market changes? Not as much as the non-professional believes they do.

Or behavioural factors, such as “herd mentality”, that may lock most analysts and money managers into a tight box. For example, 10 analysts cover a company. Consensus Earnings Per Share (EPS) for the next year is $5.00 per share and the consensus share price is $200. You see that 9 of the analysts are in a tight band, between $4.75 and 5.25 EPS. Yet the 10th analyst forecasts $1.00 EPS and a $40 share price.

Now, if analyst 10 is correct, a star may be born. Though analysts tend to only be as good as their last forecast. However, if analyst 10 is wrong, Starbucks may have a new barista.

So, what tends to happen in the real world, is that the analysts fall in line. Analyst 10 may forecast a little light, but will be much closer to the consensus. And what happens if the actual EPS is $1.00? Nothing. Analyst 10 just tells his boss that it was the company’s fault. His analysis was accurate. Just look at how 9 other analysts came up with pretty much the exact same conclusions. Bonuses for all!

And yes, there are a few analysts that have built a reputation for contrarian opinions. Marc “Dr. Doom” Faber is one who always comes to mind. But, it is often better to stay within the herd, rather than get picked off one by one for faulty predictions no one else agrees with.

“How can DCA help me manage my investment risk?”

DCA does exactly what is says. It builds an investment portfolio by dollar cost averaging over time.

You invest a fixed dollar amount on a periodic basis. Say, $1000 (plus $10 transaction fee) every 3 months.

Perhaps a stock trades at $100 on January 1, 2019. Your $1000 gets you 10 shares. April 1, the stock trades at $125. You can only purchase 8 shares. July 1, the stock trades at $90.91 and you buy 11 shares. October 1, it trades at $83.33 and you buy 12 shares. On December 31, the share price is $110.

Had you been able to invest $4000 in a single lump on January 1, you would have 40 shares with a value of $4400. For a nice gain of 10%.

Had you used DCA, you would have bought proportionately fewer shares in up markets and more shares while they were “on sale” in a down. Under DCA, you would have 41 shares instead of 40 at year end.

A simple example. In an up market, under DCA you would have less than 40 shares. Regardless, it does help smooth out asset volatility (i.e., investment risk).

From the data in the video, you can see markets (nor assets) seldom appreciate in a straight line. Smoothing out market volatility may be more prudent than trying to actively time market fluctuations.

For a little more information on this sub-topic, please refer to “Why Use Dollar Cost Averaging?”. We will also flesh out how DCA helps manage portfolio risk in subsequent episodes.

Another issue is funding. In the real world, few investors have cash sitting around on January 1 to finance an initial lump sum investment. That lack of ready capital is also a potential positive for DCA. Something we will discuss in “Episode 46: DCA: ‘Smaller’ Investors”.