Then a friend showed me an article about the fallacy of dollar-cost averaging.
Indeed, I mentioned in my previous post that dollar-cost averaging depends much on the point where the prices are; if one started low, the accumulation will be fast.
But the result of averaging is not average. At times when prices are low, units accumulation takes place. When prices are high, the additional units also contribute to the total value. Units are the one generating dividends too. In good times (prices are high), dollar-cost averaging suppresses costs. In bad times when prices are low, dollar-cost averaging helps consolidate units.
Dollar-cost averaging is a lazy-man style of investing in auto-pilot. It makes sense if investing costs are low. Obviously, it cannot do better than the Buy-Low-Sell-High (BLoShi) strategy, as I will show later. But the DCA has its merits over the BLoShi too, which I will also share my thoughts later.
DCA Vs BLoSHi. Fight!
I have extracted the maximum data (month) from Yahoo! Finance and coded up the following charts using Python. The hypothetical investing strategy is that I am investing $100 per month since 2009, when G3B debutted into the market.
The BLoShi Approach
In the BLoShi approach, funds are accumulated since the start and maximum units will be bought with all the funds accumulated when the price is below the average price of the DCA method. As shown, there are 5 points that mark this criteria. I shall assume that I enter at only two of these - the first (31-Aug-2011) and the last (31-Jan-2016).
The expected result is that this approach would definitely fare better than the DCA. As we shall analyse in the next chart.
DCA Vs BLoSHi. Performance
The following chart shows compares the value of the units held for the whole period in consideration.
The relevant numbers are:
With DCA,
Total Amount invested = $10,800
Total Units Bought = 3839
Total Value = $13,669
Total Yield = 26.565%
BLoSHi (Without DCA)
Total Amount invested = $8,400
Total Units Bought = 3280
Total Value = $11,678
Total Yield = 39.027%Due to the perpertual nature of the DCA, the amount accumulated in DCA is definitely more than the approach without - 600 more units as shown. The costs and holding value will also be higher.
Note that the analysis does not include the dividend yield.
A Simple Principle in Investing
"Buying Low and Selling High" is one of the principles of investing. "Buy a dollar for 50-cents". How low is low and how high is high? There are many metrics to determine that. For the lows, some use the 52-week low to gauge, the same is true for the highs. This form some-sort of a price resistance (I am not a trading pro BTW). Some use moving average over a certain period - if the price is below that MA, buy; if the price is above that MA, sell! Simple enough. Of course there is also the almost-mythical intrinsic value.
We may determine the intrinsic value, but we are able to make a best guess of it. Personally, I would say that numbers that are backed by fundamentals. i.e. there is a basis, is probably the more reliable one, because I cannot find satisfactory answers to question like:"How do we know if the price is going to break the 52-week high (or low)?", "How do we know if the prices will go lower even after falling below the MA?". To the latter question, one way is to keep buying, of course.
The Problem with BLoSHi
BLoSHi seems like a very sound investment strategy, I just wait out for the price to be low enough to buy and sell when the price is high enough. However, the investment strategy is oversimplified. Let's look at the statement again, this time I will italics the key words:
I just wait out for the price to be low enough to buy and sell when the price is high enough.In essence, there is uncertainty in the price movement and the time. Firstly, I need to determine the price - how low/high is adequately low/high to buy/sell? In the above analysis, it is retrospective. It is easy to pin-point prices that are lower than a certain value (an yearly average, for example) on a historical price chart like the above. Again we can use various metrics (discussed above) to determine the price to buy with some confidence.
Next, when prices are live, and when it shows that the price is trending down after a peak, not many of us will be able to overcome the psychological barrier (fear, that is) or the discipline to buy even if it is near the low that we are waiting for. That is because nobody is certain where the price is going - is it going to bottom out? What if it crash?
Finally, holding out cash to wait out for the price to reach buying-low is not efficient at all. There are much opportunity costs to this approach. In the example above, it is more than 5 years between the two purchases (Aug 2011 and January 2016). Consider the amount that could have been paid out. Assuming that the price remains stable at $2.50, a monthly contribution of $100 will allow me to buy 40 units. In a year I would have accumulated 480 units, and 2400 units in 5 years. If each unit pays out 2% or 0.05cents dividends every year, I would have missed out on $360 of dividends in total, that is more than 3 months' worth of contribution.
With 2% dividend, the yields presented above will be about 29% and 39% for the DCA and Non-DCA cases respectively. As mentioned, the BLoSHi has forgone the compounding effect of any dividends.
Conclusion
Dollar-cost averaging is not a perfect investment strategy. Honestly, in my opinion, it cannot beat the market per se, but it helps to suppress costs when prices are high and accumulate units when prices are low. Here 'highs' and 'lows' are relative to the average price. It also helps one stay invested without the psyhchological barrier when prices dip, and it optimizes the effect of compounding. It also helps negate the need for large capital outlay. This way, we still can get back a fair share from the stock market even though the outcome may not be as stellar as the BLoSHi approach, which I shared that there are many barriers to apply efficiently. However, this is all in the pretext that the investing costs are low.
Perhaps, to optimize the results, one way is to increase the contribution when the prices are low. Maybe I shall leave it for another time.
Do feel free to air your comment!
~ZF
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