We all know that Dollar Cost Averaging is an excellent way to improve returns, earning even more than the long-term return of the assets in which you’re investing. This is accomplished as DCA forces investors to buy more at relative lows and less at relative highs over the life of an investment. This is difficult to do on a discretionary basis because of a number of our cognitive biases, but the systematic nature of DCA eliminates our emotional overrides and simply takes advantage of changing asset prices.
So given that DCA is a great strategy, we ask if it is strengthened or weakened by additional volatility? Common industry knowledge tells us that volatility is bad, something that needs to be justified by returns. When you are implementing a DCA strategy, however, volatility is objectively a good thing – and the more the merrier.
Example: Assume two investments, X and Y, have the same long-term rate of return. Also assume that investment X has a higher level of volatility then investment Y – it reaches higher relative highs and lower relative lows over the invested period. (At this point, all investment textbooks tell you it is a no-brainer to invest in Y.) As we proceed with our DCA strategy, a market decline impacts the price of X by -50% and Y by -25%. Our fixed-dollar investment (the cornerstone of DCA and retirement saving) buys much more of X at the deflated price than Y. Then the price of X rises much more than the price of Y during the subsequent recovery, and we buy less of X than Y at the inflated price. Continuing our DCA strategy, rinsing and repeating the above, we end up with a much lower cost basis for investment X, thus generating a much higher IRR in X, even though X and Y had the same long-term performance.
Without exception, it is better to select the higher volatility asset when executing a DCA strategy and deciding between two investments with the same long-term return. In this way, volatility is the friend of the DCA investor. There are many corollaries that stem from this realization, which will be covered in future posts. For now, let’s just establish that the group of people using DCA is enormous, comprised of every American with a 401(k), and as of yet no one has told them about the benefits of volatility.
Dave Donnelly is the Founder and CEO of Strategic Alpha, a rebalancing service dedicated to helping financial advisors improve client outcomes. www.Strategic-Alpha.com