Dollar Cost Averaging, Is it an optimal strategy?

[alexei]

I'm trying to figure out an optimal strategy to buy ETF shares. The simplest way for me is to buy once a week (dollar cost averaging that is). This strategy does assume that the commission is free or very low. If I buy XUI then the commission is $1 per transaction, or 0.2% per 500-dollar transaction. HXT is free at Virtual Brokers. I'm planning to invest 300-500 per week. One question to have is when to buy during a week

I did some calculations yesterday for Royal Bank for the period of Jan 1, 2007 until Aug 13, 2012. If I spent $500 every week at the market close price then my average share price would have been 50.405. The actual price yesterday was 50.9. The calculation assumed that I could buy partial shares for simplicity. Frankly, I'm not quite impressed with this result. I've noticed that during the crash of 2008, I would have bought a maximum of 18 shares per week, but since the market dip was only a few months long the average still ended up similar to today's prices.

I would like to explore a method of scaling the monthly investment sums depending on where the market growth. For instance, if the market has grown by 2% and I would only invest 500*0.98%, the other 2% going to bonds/preferreds. The tricky part would be to determine when to start applying the scaling.

[MoneyGal]

Milevsky and co-authors examined the same issue (as have many other finance academics) here: http://papers.ssrn.com/sol3/papers.c...ract_id=148754

I'm trying to find a linkable non-"mathy" version of that paper (which doesn't use terms like stochastic, for example). There's a chapter in Milevsky's Money Logic which is a non-"mathy" version of the same paper.

Bottom line is that in most circumstances, DCAing just increases your exposure to volatility. It has enormous emotional appeal, though, because you can justify your decision no matter what the market does.

[Sampson]

Mathematically, DCA only works in rising markets, and even then, performs worse than a lump sum as an initial investment. How DCA seems to work best is to remove the human emotional aspect from investing, lest one fall into the trap of buying high and selling low that happens so often.

Dollar value averaging might be a better choice, but in essence it is a form of market timing and dependent on efficient markets and fundamental analysis.

[alexei]

The idea of passive investing seems to be very popular these days. I have this question. Wouldn't the people who buy index funds have to employ DCA by default? I mean, an average investor like me has a certain amount to invest, say, every two weeks . I have no idea what will happen to the markets in the future so I would have to just invest that money on a bi-weekly basis. The only exception is when an obvious market crash occurs (a drop of 10-15% or more) then the passive investor could put extra money into his or her index funds.

In general, I'm debating with myself on whether to buy individual stocks or ETFs. Originally I started off buying individual shares but that activity takes too much personal time and emotion.

[doctrine]

DCA'ing works because it is a plan, and it keeps you investing when markets are down.

I personally use DCA, and invest more when markets are down. I don't have a magic formula, but would suggest that every 10% drop in major indexes from either recent or all time highs is an indication of a buying opportunity. For example, I invested twice as much last August, September and October after the TSX dropped below 12k. I have also been investing more heavily since May when the TSX dropped below 12k again. But different stocks were on sale on both occasions, so some work was required.

If I was in indexing, I'd much rather buy XIU when the TSX was under 12k, especially when you know it was at 15k in 2007. Not only are you buying at a 5-8 year discount, the world and Canadian economies are significantly larger in nominal terms than in 2007, and the TSX composite is a nominal number, not inflation adjusted.

[MoneyGal]

I have this question. Wouldn't the people who buy index funds have to employ DCA by default? I mean, an average investor like me has a certain amount to invest, say, every two weeks.

This is technically "periodic investing," not DCAing. There's no point discussing how to optimally invest funds you don't actually have.

[Sampson]

There's no point discussing how to optimally invest funds you don't actually have.

Too true... and funny.

[Cal]

I would say that I don't intentionally DCA however I do unintentionally DCA.

In that I select where to deploy my $, select my buy price or entry point. Whenever I decide to buy more of that stock either to rebalance the portfolio, or b/c it has once again reached a price point (not necessarily the same one) that makes it a fair buy, then I buy more.

I guess it really comes down to what kind of a time line you are looking at.

IMO, if you feel something is a good buy and have the money, back the truck up. If you seem to end up with $500 every week to invest and want to buy etf's, then just try to buy low, based on the weekly trading range and the momentum of the markets.

[alexei]

All right, I've decided to run some numbers. The parameters of the test were as follows:

Time period: Jan 1, 2007 - Aug 13, 2012
Buying frequency: weekly
Price: weekly close
Required wealth value increments: 500 per week
Expected rate of return: 6%
ETF: XIU

The results are as follows:

DVA contributions: $171557.6448
Present day value: $173315.57
Total shares bought 10165.14
Avg share price: $16.87706374


DCA contributions: $146500
Present day value: $141519.69
Total shares bought: 8300.28
Avg share price: $17.65001722

Today's closing XIU share price is 17.04. Investing 500 every week (dollar cost averaging) would result in an average price of $17.65. With dollar value averaging, the average share price ended up $16.87 but the approach required more contributions.

It's also interesting to note that both DVA and DCA investors would currently be even in terms of what they've invested and the current market price of the investment. Of course, the time frame chosen had much to do with these results.

[Sampson]

Doesn't you example actually show that the DVA strategy outperforms by nearly 5-6%? nominal value over the time period?