MUTUAL FUNDS & DOLLAR COST AVERAGING

Here’s another email exchange some of you might find useful. Joe wanted to know what the difference is, over time, between Rule #1 style investing and the “dollar cost averaging” of investing a set amount per month in mutual funds. 

Here’s his question and my response… as well as a follow-up email from him.

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Date:   June 16, 2005
From:  Joe
To:      Phil

Hello Phil,

I recently heard your talk at the Get Motivated! seminar in Philly.  Your market charts depicting sideways/zero growth for huge chunks of time over the past 100 years really got my attention about my current investment strategy.  I’ve been doing a lot of thinking about your investing philosophy vs. simply making systematic investments in an S&P 500 type index mutual fund, and the only plus I can possibly see for the index argument is dollar cost averaging.  I’m sure you are familiar with the argument: by investing regularly (e.g., same $ amount every month) in a mutual fund, you are guaranteed to buy fewer shares when the price is high and more shares when the price is low. Thus, in the long run, you are virtually guaranteed to profit regardless of how the market does.

I’d like to see a comparison of the profit generated using the Rule #1 method vs. dollar cost averaging in an S&P500 Index fund during a 0% growth year in the S&P.  I’m sure it would vary a lot, depending on how much up and down there is in the market that year, but it seems like a reasonable question (especially since most index mutuals don’t charge a commission for systematic investing).

Your thoughts?

Joe

Date: June 17, 2005
From: Phil
To:    Joe

Hi Joe,

Dollar Cost Averaging helps you keep your money but it does not guarantee a profit, much less a nice retirement, if the market drifts for twenty years. 

For example, if you start in 1905 at 100 and dollar cost average in monthly for a total of $10,000 a year, your compounded ROI over that 37 year period is 0%.  You’ve put in $370,000 and have $364,000.  If you did government bonds the same way adding $10k per year with 4% average ROI you’ve got over $850,000 by 1942. 

A look at 1965 -1983 gives a slightly different  result – one that is more in line with what you were thinking:  At the end of 18 years you put in $180,000 and have $196,000 to show for it for a 2% return.  And a look at the same thing from 2000-2005 gives you $55,000 in 2005, a 5% annual 5 year return, but if the market continues to go sideways, that ROI will drop to the 1965-1983 scenario, i.e., t-bill rates or worse. 

In addition, of the biggest problems with dollar cost averaging is whether an investor is willing or even able to put in more money at exactly the time they most need to – at the market bottom. Consider that in 1930 a $500,000 portfolio went to $75,000 in one year.  How many people have their emotions under control enough to buy in after that?  And where are some of them going to get the $10,000 to shove in there if they don’t have a job?

That caveat aside, dollar cost averaging can keep the ship from sinking and, therefore, is a legitimate long term strategy.  The best first choice, of course, is to start buying dollars for fifty cents.  If you can learn that, instead of using the market bottoms as an opportunity to average out the overpriced buys you made at market tops, the market bottoms are opportunities to get rich. 

Consider the price of ignorance and non-involvement in number terms: At least for the foreseeable future, it could be the difference between 2% and 20% per year.  A 50 year old with $50,000 (the average for about 75,000,000 boomers), at 2% putting in $10,000 a year for the next 20 years, will retire with $223,000 in today’s dollars (yup, less than the dollars they put in), while at 20% they retire with $2.5 million in today’s dollars. 

That’s a big difference in the way people might live in retirement if they dollar cost average in a flat market vs. learning to buy wonderful companies at attractive prices.

Phil

Date: June 20, 2005
From: Joe
To:     Phil

Hi Phil,

Thanks a ton for crunching the numbers on my dollar cost averaging question.  Once again, eye popping stuff!  You are more than welcome to use my question on your blog.

I have already learned so much just by applying the value principles you’ve laid out to stocks I already own and stocks I’m interested in.  (I dumped almost all of them and am trying to exercise patience while I learn more good stuff before jumping back in!) I’ve had a pretty undisciplined approach to investing over the past 5-6 years and I am stoked about the opportunity to learn a strategy & get a hold of some tools that will work for a change!

By the way, I invested in WFMI back in 1999 when I first got back from Japan.  My wife and I used to make special trips from Dover to Annapolis just to shop there ‘cause we loved the store so much.  I think the price was about $15 a share, and I bailed a few months later at around $21, not because I had any strategy–I just got nervous with success!  Never got back in either cause I didn’t know how to value the market price and was spooked by the P/E. Thanks for providing the tools that will allow me to find great companies and stick with them intelligently!  You’re a good man.

God bless,

Joe

P.S. – My only reservation now is that little voice in the back of my head that is asking, "Why should you trust advice from a guy who almost paddled a bunch of businessmen/tourists over a waterfall in the Grand Canyon?" (Ha Ha)