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Tickers in this Article: SPY, VTI, IYY, SCHB
Sometimes, the behavior and scope of capital markets goes beyond conventional research and financial logic. This is one of the major reasons for huge volatility witnessed in the financial markets, and it has pretty much been the state of affairs for investors for quite some time now (read What Do Quarterly Trends Reveal about ETFs in Q4?). While there are tons of ways in which an investor can ride this uncertainty, not all of them prove to be fruitful. In the light of the above statement, we would like to discuss one such strategy which has time and again proven to be helpful to investors.

Dollar Cost Averaging

This investment strategy involves allocating a fixed sum of money to a particular investment avenue at regular intervals, irrespective of the bullish or bearish bias in the market.

For example, you allocate a sum of money (say $1,000) to buy shares of SPY on the 1st of every month for 12 months. This implies that irrespective of the market conditions (i.e. bullish or bearish), you will buy equivalent number of shares of SPY worth $1,000 every month at a specified date.

As a mathematical implication of this phenomenon, with your investment amount being constant (i.e. $1,000), you will buy more shares when the prices go down and less shares when the prices are up (both offering substantial room for capital growth) (see more in the Zacks ETF Center).

By doing this investors i) don't have to worry about timing the market, ii) can potentially bring down their average cost of investment, iii) reduce volatility to a great extent.

ETF Approach to DCA

This strategy can be applied to any investment vehicle; however, it is particularly intriguing when it is tried with ETFs. Their i) flexibility in terms of ease of trading ii) low cost structure and iii) basket approach which reduces concentration risk, make them appropriate avenues for dollar cost averaging.

Let us understand how this strategy would work with ETFs with a help of a real life example based on real events. The time horizon is 18 months from Jan 2011 to June 2012 and it is assumed that the shares are bought on the first trading day of each month at their then market value.

The time horizon taken into account was an extremely volatile period and three distinct broad market ETFs are considered as these ETFs would serve as a pretty good sample to reflect the total equity market sentiment in the U.S (read Comprehensive Guide to Total Market ETFs). These ETFs are - Vanguard Total Stock Market ETF (VTI), Schwab U.S. Broad Market ETF (SCHB) and iShares Dow Jones U.S. ETF (IYY).

The following table shows the number of shares bought monthly for $5,000 at the then market prices for three distinct broad market ETFs for a period of 18 months (i.e. 1.5 years). At any date, the number of shares is ascertained by dividing the investment amount (i.e. $5,000) by the current market price as on that date.

 

Date
Market Price (VTI)
No. of Shares (VTI)
Market Price (SCHB)
No. of Shares (SCHB)
Market Price (IYY)
No. of Shares (IYY)
Jan 2011
63.43
79
29.72
168
62.07
81
Feb 2011
65.13
77
30.53
164
63.88
78
March 2011
65.32
77
30.62
163
63.97
78
April 2011
67.04
75
31.4
159
65.51
76
May 2011
68.53
73
32.11
156
67
75
June 2011
66.38
75
31.12
161
64.92
77
July 2011
67.66
74
31.72
158
66.18
76
Aug 2011
64.9
77
30.45
164
63.55
79
Sept 2011
60.53
83
28.42
176
59.33
84
Oct 2011
54.71
91
25.73
194
53.74
93
Nov 2001
61.34
82
28.81
174
60.09
83
Dec 2011
62.78
80
29.46
170
61.48
81
Jan 2012
64.29
78
30.21
166
63.06
79
Feb 2012
67.38
74
31.61
158
65.82
76
Mar 2012
69.95
71
32.81
152
68.43
73
April 2012
72.15
69
33.84
148
70.64
71
May 2012
71.55
70
33.56
149
69.99
71
June 2012
64.95
77
30.49
164
63.69
79
Total No. of Shares
 
1,381
 
2,943
 
1,410
 

 

 

 

 

 

 

 

 

 

 

The table suggests that as the market price increases, fewer numbers of shares are bought; however, as the prices go down, a greater number of shares are bought (obviously). Nevertheless, the total number of shares bought for VTI over a period of 18 months is 1,381; for SCHB it is 2,943 and for IYY it is 1,410 (read Guide to Most Popular ETFs).

Payoff at Redemption

 

Data Point
VTI
SCHB
IYY
Total No. of Shares Bought (A)
1,381
2,943
1,410
Redemption Price (B) (as of 30th June 2012)
$69.36
$32.52
$67.82
Redemption Value (A*B)
$95,786.16
$95,706.36
$95,626.20
Total Investment (18 months * $5000) (C)
$90,000
$90,000
$90,000
Average Cost per share (C)/(A)
$65.18
$30.58
$63.83
Internal Rate of Return (IRR)
0.65%
0.64%
0.64%
Annualized IRR
8.08%
8.00%
7.89%
Annualized Return (in case of a lump sum Investment of $90,000 instead of annuity over a period of 18 months)
6.14%
6.19%
6.08%
Although a lump sum investment in each of the ETFs would have resulted in a larger capital appreciation than dollar cost averaging in terms, yet on an absolute basis, the annualized rate of return on dollar cost averaging investments is superior to that of a lump sum investment.

This has happened because of the fact that with a lump sum investment a larger portion of funds are tied up. However, on the basis of annuity, the entire investment amount is spread out over a long period of time and the investor has funds at his/her disposal in case he/she needs it and availability of money is a very big factor to consider before selecting an investment avenue.

Therefore the technique also factors in the opportunity cost (i.e. the returns that would have been generated from the next best investment avenue) of the lump sum investment (read Two ETFs up more than 140% YTD).

We use the annualized internal rate of return to ascertain investment returns on an annuity basis and compounded annual growth rate to measure returns from a lump sum investment.

The table above suggests that on an annualized basis the investment of $90,000 over a period of 18 months would have grown by 8.08%, 8.00% and 7.89%, respectively, for VTI, SCHB and IYY, in case of dollar cost averaging, but the same $90,000 would have grown only 6.14%, 6.19% and 6.08% in case of a lump sum investment.

Drawbacks

It is true that dollar cost averaging significantly reduces the probability of huge losses; however, it also limits the upside potential significantly. Of course, using this investment strategy, an investor does not need to worry about timing the market but if one is confident of the direction of market movement, a lump sum investment would any day be a better option.

Nevertheless, dollar cost averaging can prove to be a great choice for investors in an uncertain and highly volatile market, like the one we find ourselves in now (see Uncertain about the Economy? Try Market Neutral ETFs).

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