Dollar Cost Averaging

brainactive on 18/11/2016 - 12:44
Last edited 18/11/2016 - 12:46

Dollar Cost Averaging (DCA) is a strategy where the investor places a fixed dollar amount into an investment on a regular basis (e.g. $1000 into a stock every month for 7 years). When prices rise, the investor will purchase fewer shares and when prices decline, the investor will purchase more shares. The idea is to reduce market risk by smoothing out the volatility in share prices.

This all sounds well and good, until I did some calculations on the Vanguard Index ETF VAS.AX. To get prices over time, change option to "Monthly" and click "Get prices", then "Download to spreadsheet" at the bottom of page.

I assume monthly investment of $1000 and final valuation date being November 2016. If I started investing in May 2009 using the DCA strategy, I will have purchased 1458.293 shares and at current price of $67.29, the $91,000 investment over ~7.5 years would be worth $98,218. This is an investment return of ~1% p.a., which is excruciatingly low!

Now, Vanguard Index ETF is a very well diversified investment, combine this with the fact that we are looking at a decent time horizon of almost 8 years and using the DCA method to further diversify market risk, you'd expect at least decent returns, and not something which is much lower than inflation!

I've also tested alternative scenarios, where I start investing using this strategy not in May 2009 but the other possible months before Nov 2016 and similar returns are achieved (and in many cases lower than 1% p.a. return).

Any comments on this strategy or stock and why the returns are so measly? Note that investing the $91,000 straight up on May 2009 (rather than using DCA method) would lead to a final investment worth $120,968 (which is ~4.5% p.a.).

Financial

Comments

  • inherentchoice on 18/11/2016 - 12:53

    Well I do DCA with fuel for my car. Pretty sure it saves me a fair bit.

  • djsweet on 18/11/2016 - 12:56
    +6

    You only get 7 years of growth on the very first share purchase, every subsequent share purchase has less and less time to grow…
    So of course you will get less returns this way than if you put all 91k in right at the beginning.

    • brainactive on 18/11/2016 - 13:00

      Yep, that is very true, my mistake. But even with an average duration of 3.5 years, returns are around 2% p.a. which is still very low.

  • jackofspade on 18/11/2016 - 13:07
    +7

    I don't think you have included dividend distributions.

    • competecarrot on 19/11/2016 - 12:58

      This is the correct answer. ASX is apparently dividend heavy. It will add at least 2% annually if I recall correctly.

  • JCrown9 on 18/11/2016 - 13:46

    your probably right if you invest monthly.

    Thats why historically its best to purchase products in the last week of september. Historically Sept is the worst month of the year, and sees the most growth in the coming 12months.

    If you re did your figures based on that, and included dividends as mentioned above, youll see the returns are likley much higher. Taking into account a DRP, this compounds your growth even further for even larger returns :)

    Or do the same calculations on different funds, indexes and stocks and see what performs best.

    Good luck.

    • brainactive on 18/11/2016 - 14:48

      Any reason why last week of september is the worst month of the year?

      • scotty on 18/11/2016 - 22:26
        +1

        Usually after the companies pay out the dividends? Usually they do that at the end of March & September, and the share price would drop by the dividends/share paid.

  • mskeggs on 18/11/2016 - 14:12
    +6

    The time frame you picked includes over 20% price growth. You will always do better investing a lump ahead of growth than an average.
    Run the numbers again from say, Dec 2010 to Feb 2016 when the index was flat, and you will see DCA is pretty flat too.
    Now try Jan 2010 to Jul 2012, a down period in the market (their figures don't go back before 2009 to figure a real downturn) and you will see DCA comes out ahead.
    In all cases, you get the benefit of interest on the cash you hold over the period (assuming you have the option of investing the total amount on day 1 versus DCA). While interest is low today, it has been substantially higher at times over the last few decades.

    So what can you conclude? As you can't know for sure if prices are high or low (remember if you bought in 1929 when prices had dropped 50% you would have still gone on to lose 80% of your money to the low) DCA gives you insurance against disaster at the expense of moderating your returns in the good times.

    Looking at a graph of the index, I don't think you can conclude we are sure to have continual growth in future, probably most likely to have a mixed outlook. If you want insurance against a fall in the short term, DCA gives that.

    • brainactive on 18/11/2016 - 14:43

      My concern isn't so much that a lump sum investment outperforms DCA in the good times, this is expected. The concern is more about the extent to which DCA dilutes returns during the good times. Return using DCA seems to be similar to (or lower than) holding cash, which is not expected for a well diversified stock (such as Vanguard Index ETF) over a long time horizon, in a moderate growth environment.

      So I'm wondering if mathematically, the moderating of returns during good/bad times using DCA is symmetric (i.e. relative to lump sum method, whether the reduction of returns during the good times is of the same magnitude as the increase of returns during the bad times).

      • mskeggs on 18/11/2016 - 15:04
        +1

        Yes, DCA will be symmetrical, but as the market trends upwards over time, DCA will have a cost over a long time horizon, assuming the historical uptrend continues.

        "Return using DCA seems to be similar to (or lower than) holding cash"
        No, the return on holding cash is zero for capital growth, if you exclude interest income. You need to include the ETF dividend income as well if you want to compare total returns.
        If you wanted to be particularly sophisticated, you would also need to include the taxation consequences, as interest is taxed as income, but dividends are often franked and capital gains taxed concessionally. And the picture evolves with your tax situation, so if you intend to hold till after you retire, for example, that also has implications.

        I know this sounds complex, but it can be reasonably summarised as:
        - shares total return has traditionally been worth a couple of percent over cash interest
        - DCA is insurance against dramatic market falls, but moderates returns. Probably best employed in a halfway strategy (i.e. don't make a single lump investment, but don't make 90 small investments either. Maybe 5 investments over several years to optimise risk/return?)
        - depending on your tax situation, different investments have different benefits. If you are a normal income earner, capital gain is good. If you have no taxable income, franked share dividends are excellent, for example.

        • brainactive on 18/11/2016 - 16:04

          Ok great thanks, this is a clear explanation.

          You mentioned that "dividends are franked and capital gains taxed concessionally". So what are the precise rates and rules regarding franking/capital gains. Would like to try add it to my calculations.

          Need to start making some decisions on how to invest. Been delaying it for a few years while getting crappy rates from online savings accounts. Tossing up either indexed funds or some property. Don't think cash is going to cut it anymore.

        • mskeggs on 18/11/2016 - 16:20
          +1

          @brainactive:
          Franking is when the company pays tax on its profits and uses those profits to pay the dividends.
          Any tax they paid is counted toward your income.
          So some share pay a fully franked dividend. This means it has tax paid at 30% (the corporate rate).
          If your marginal tax rate is 30%, you don't have to pay any extra tax on this income. If your tax rate is 45%, you pay the difference (15%). If you do not pay any tax because you are on a low income or retired, the ATO will refund the 30% tax already paid to you!

          Unfortunately, the degree of franking varies by company. Many who get most of their profits in Australia pay fully franked dividends. Some pay partially franked, and will tell you what percentage was tax paid. Some pay dividends with no franking. It is something you can look up in the annual report or the dividend announcement.

          Capital gains are taxed at your marginal rate, but if you hold the asset for over a year, the amount of the gain is halved for tax calculations.

          I applaud you taking the bull by the horns and calculating this stuff. A lot of people put it in the too hard basket and are vulnerable to scams or misleading offers.
          My suggestion would be to look skeptically at property in Sydney and Melbourne especially - where can price growth come from?
          Shares are more volatile, but most funds and ETFs will show you a total return figure that includes income and should tell you of any franking benefit (actually, I'm unsure about that last bit) that will make comparisons between different funds more easy than calculating everything from scratch yourself.

          My absolute strongest piece of advice is to buy low and sell high. It is so attractive to want to join the herd when you see people who have done very well in property recently, or sell when stuff looks grim. But if you can do the opposite there are the best opportunities for success.

        • brainactive on 18/11/2016 - 16:59

          @mskeggs: Agree that there is no basis for strong price growth in the long term (> 8 years). However, I'm at the stage where I can get a loan and pay it back in 6-7 years. My initial thoughts are there is still some juice left in the market. Even if the next few years is followed by subdued growth, it is still likely to be growth nevertheless and combine this with the rent I'll be receiving, it may still come out on top of say Vanguard ETF, where growth is also not guaranteed and arguably even less certain in the short term. My third option is to continue investing in cash, which is just starting to get a bit embarrassing considering my entire life saving to date has been stashed in multiple online savings accounts and it's not the amount that is typically meant to kept there.

      • railspider on 18/11/2016 - 15:10
        +2

        How are you meant to know when the good times are? The whole reason to use DCA is because no-one can tell what the market is going to do over the medium-term.

  • thefreelunch on 19/11/2016 - 08:05

    They're many long periods when equity markets don't deliver. Have a look at the recent Challenger paper - "The (un)Predictable Equity Risk Premium". It analysed equity market returns since 1900 across 21 countries and found an approximate one-in-five chance that 20-year historical equity returns would be lower than the risk-free return. Timing (luck) can play a big role even over the so-called long term.

  • moar bargains on 19/11/2016 - 20:10
    +1

    Now, Vanguard Index ETF is a very well diversified investment

    I would argue that this isn't really true for VAS because of the way the Australian index is weighted. I.e. 4 of the top 5 companies are our biggest banks. The top 10 make up 50% of the top 100 by market cap (or 42% of the top 300, which is what VAS is made up of), and almost all of them have faced issues in the last few years negatively affecting their profitability and share price. 5 are banks and have faced margin compression, two are Supermarkets losing market share to Aldi, one is a Telco which hasn't grown profits in 10 years, and one is a mining company exposed to the iron ore price crash last year. The only one left is CSL.
    Hence, because of the index weighting, 50% of the ETF is concentrated in 5% of the companies. Buying 4 different banks doesn't count as diversification.

    I would be very interested in how this strategy performed using something like VTS (US market weighted), or a midcap ETF or even a LIC. I reckon you'd find it was a different story.

  • Oofy Doofy on 19/11/2016 - 21:22
    +1

    Check out a fundamentals index and/or an index that removes the mining and financial sectors.

    I prefer a fundamentals index, and hedge by removing the top heavy miners and financials.

    Not financial/investment advice, just personal opinion.

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