Last week's column on dollar cost averaging needs some addressing. First, you should know that the original headline read "Dollar cost averaging not for beginner investors." I don't write the headlines, and it certainly framed the column in a different light than what I was intending. The revised headline now reads "Dollar cost averaging: How it works and how it doesn't."
Framing the column with one headline versus the other would certainly affect the reception of the main messages. Here are the takeaway points:
Dollar cost averaging is not really a choice for beginner investors. Many people begin investing by making small monthly purchases because that's the only way they can get started.
Dollar cost averaging becomes more of a choice later on when an investor is contemplating deploying cash or switching between investments with a lump sum - this allows one to decide whether they should get into an investment now with the risk of buying at a peak, or take an average price over a period of time by averaging in to the investment.
Taken in this context, DCA decreases your cost base if the investment wasn't at a peak. It increases your cost base if the investment was at a peak. If the investment was volatile over the period you averaged in, DCA actually gives you a cost base below the average price of the investment, since you buy less units when the price increases and you buy more units when the price decreases.
So why did I open this can of worms? Because while most people have heard about dollar cost averaging (DCA), fewer are familiar with a concept known as dollar value averaging (DVA). There have been some studies that have shown that DVA is superior to DCA in most market scenarios. How much more superior? Former Harvard professor Michael Edleson provides data to suggest it's in the ballpark of a 1 per cent better rate of return.
DVA is kind of like DCA on steroids. Instead of mindlessly contributing a fixed amount of capital on a periodic basis, DVA contributions are quite dynamic and require some math every time you make a contribution. And some months, you might even take money off the table by redeeming.
DVA requires you to peg an expected rate of return for your investment. Let's assume you've picked a 4-per-cent rate of return, and you've decided to contribute monthly. You have $12,000 in cash that you want to deploy over one year. DCA would have you putting $1,000 per month into your investment. DVA is a different story. The contribution (and sometimes withdrawal) depends on the actual performance of the investment. If it does really well, you contribute less, and sometimes you might even sell units. The best way is to explain with tables.
As you can see, with DCA you would just put in your $1,000 monthly and your total contributions would have been $12,000.
DVA, on the other hand, requires you to calculate what your portfolio should be worth at various points in time and adjust accordingly. The "Required Value" column below is simply $1,000 per month with growth of 4 per cent a year or 0.33 per cent a month. If the investment is increasing in price, you buy fewer units. If the investment is doing poorly, you buy more units. Just like DCA, except more so.
The key to understanding the table below is to take the predetermined required value and divide that by the current unit price. This gives you how many total units you are supposed to own at that point in time. Subtract the units you owned from last month and this tells you how many units you need to buy this month in order for the portfolio to hit your required value amount.
As you'll see, the total outlay in this scenario would have been only $10,716.15 with DVA versus $12,000 with DCA. Yet you had almost the same ending value of roughly $12,200.
So what are the drawbacks of DVA? You'll need time to figure out how much to contribute each period, and the contributions will have to be done manually. It's best suited for a registered account because if you did have to sell units on occasion, this would incur a tax drag in non-registered accounts.
You would also require very flexible cash flow. Note that month nine of the DVA schedule required a $3,050.43 contribution. It goes back to my point of when this is even feasible as a choice: when you have a lump sum to deploy, not when you are just starting out with your investing career. Who can suddenly triple a regular contribution without causing a serious cramp in their monthly household budget?
Further, you'll need to estimate a rate of return for your given investment, which is a whole other kettle of fish.
With either DCA or DVA, if you are deploying a lump sum over time, they will both lose out versus dumping the whole thing in the market if the investment has a strong upswing immediately. Vice versa, either DCA or DVA will outperform a lump sum investment in a downswing or a volatile sideways market, and DVA can offer better risk-adjusted return on your capital than DCA.
So to my original point, DCA isn't much of a choice until you have a lump sum of cash to be deployed. If and when you get to that point, it should also be understood that DVA may be better than DCA for those inclined to spend the extra effort involved, providing they have the discipline to execute it according to plan.
* Here is a link to some research into DVA versus DCA.
Preet Banerjee is a senior vice-president with Pro-Financial Asset Management. His website is wheredoesallmymoneygo.com.