In the 1989 classic, Back to the Future Part II, Marty returns from the past only to find that his present has taken a dark turn. Seeking some explanation, he finds Doc Brown who says, “Obviously the time continuum has been disrupted, creating a new temporal event sequence resulting in this alternate reality.” To which Marty’s response was, “English, Doc!” The point is that terminology can get in the way of understanding, especially within the financial world. So here is a plain English explanation of a technical term that is very relevant for investors in the current market: dollar cost averaging.
It is a wonderful gift to those who are steady investors and a powerful mathematic principal as important to saving as compounding interest. And even though you have probably never heard of dollar cost averaging, you unknowingly use it in your everyday life: You know when you’re at the grocery running down your list of normal purchases and discover that one of them is half off? Do you go home and complain about how the toilet paper market is down? Absolutely not—you buy an extra package. That is dollar cost averaging.
To illustrate, let’s assume there are two investors who each put $100 into the market every year: one invests exclusively in Gizmo Inc. and the other in Widget Corp., which have both increased similarly in value over the last three years. But one key difference is that Gizmo stock has been much more volatile through its upward trajectory with prices zigzagging up and down along the way, whereas Widget has slowly increased over time.
As a result, Investor 1 purchased Gizmo at $6, $4, and $8 over the last three years, and Investor 2 purchased Widget consistently at $6 every year. But both stocks are currently trading at $10. So which investor performed better? You may be tempted to say that they ended up in the same position—each bought at the same average price ($6), and both companies are now worth $10 per share. And if they had purchased the same number of shares, you would be correct. But they didn’t—they purchased the same dollar cost of shares.
Therefore, the Gizmo investor was able to purchase more units in year two at $4 per share that then rose to $10, giving him an outsized gain compared to the other investor. As a result, the Gizmo investment saw an 81% return compared to 67% for Widget. So how does this principal correlate to the overall market?
Eric Nelson of Servo Wealth Management makes that exact comparison. In the 15-year period from 2000-2014, the Vanguard S&P 500 fund earned an average of 4.1% per year, which was about the same as the Vanguard Short-term Bond Index fund. But guess what the key difference was? Just like our Gizmo vs Widget battle before, volatility changed the game.
The S&P 500 experienced seven times more volatility than the bond fund. So if you had invested $1,000 every month for 15 years, then S&P 500 portfolio would have grown to $352,202, whereas the bond fund portfolio would have only grown to $228,294, despite the same $180,000 investment. So while it may have been painful to invest in 2001 and 2008 when the market experienced major declines, those investments lowered the dollar cost average of the S&P 500 portfolio, boosting its earnings over time.
In his 1949 book, The Intelligent Investor, Benjamin Graham uses the allegory of Mr. Market to explain the irrationality of market movements. Graham tells the reader that Mr. Market is your business partner, and every day he offers to sell his share in the business or buy yours. Graham further explains that Mr. Market has a major affective disorder, so his exuberant optimism and frantic pessimism are not based on meaningful changes in the business. Given these circumstances, you would never sell to Mr. Market when he has an unreasonably gloomy outlook for the business or buy from him when he has unreasonably high expectations. Either way, Mr. Market wouldn’t be offering a good price, and you know there will be another one tomorrow.
The point is that the market has no reasonable basis for its day-to-day movement. Over time, it corrects itself, but there is no reason to get caught up in short-term fluctuations. In fact, if you steadily invest in the market, through good times and bad, dollar cost averaging will accelerate your returns and propel wealth accumulation.
Josh Norris is an Investment Advisory Representative of LeFleur Financial. Josh can be reached at josh@LeFleurFinancial.com.