How to Implement and Monitor a Dollar-Cost-Averaging Strategy

A consistent theme of the Sound Mind Investing philosophy is the importance of taking charge of your own financial future by becoming an "initiator" rather than a "responder." Initiators don't let others shape their course; they set the pace. Action is taken as a result of specific guidelines from a specific strategy coming into play. They "plan their work and work their plan." Many such plans make use of systematic "formula" strategies. A formula strategy can be quite useful because it requires that you make your buying and selling decisions based solely on mechanical guidelines. There is no judgment involved; it's all automatic. They are helpful because they protect you against your own emotions and the tendency to go along with the crowd. Such strategies fit well into the disciplined framework for decision-making desired by initiators.

Probably the best-known formula strategy is dollar-cost-averaging (DCA). It's simplicity personified. Here's all you do: (1) invest the same amount of money (2) at regular time intervals. The amount and frequency are up to you. The important thing is to pick an amount you can stick with faithfully over many years. Your constant dollar investment automatically results in buying more shares when prices fall and buying fewer shares when prices rise. In effect, you are buying more at bargain prices and relatively little at what might be considered high prices. Of course, only when you look back years from now will you know when prices really were bargains and when prices were too high.

The beauty of DCA is that it frees you from the worry of whether you're buying stocks at the "wrong" time. It is critically important to ignore all market fluctuations when employing a dollar-cost-averaging strategy. Most investors who obtain poor returns in the market are victims of their own emotions. Only after stock prices have risen sharply do they work up enough courage to buy stock fund shares. And they often sell when they become fearful after prices have plunged. The consequence is that they buy high and sell low, the very opposite of their goal. It is important, then, not to let your emotions control you. You must exercise the discipline of maintaining your systematic investment program.

Two cautions. First, DCA does not protect you against losses. While it does result in your average cost per share being lower than the average price of the shares over time, in a bear market you can nevertheless have temporary losses.

Second, DCA can lower your potential profits. If your fund's share prices had risen all year long, you would obviously have shown greater gains if you had made a single large investment early on. In fact, academic studies have appeared in recent years purporting to show that DCA is a bad idea. Why? Because the market has a long-term upward bias. Over time, the market always moves higher. The implication is that, on average, you're going to be paying more for your shares if you stretch your buying out than if you go ahead and invest as much as you can as soon as possible.

That's all well and good when you're looking back over a forty-year period with the confidence that comes from 20/20 hindsight. It ignores the fact that there are bear market periods along the way when it's quite easy for investors to be frightened out of the markets altogether. If you invest your $50,000 inheritance just before a bear market wipes out $10,000 of it, who's to say you're going to have the stomach for staying around and waiting for the next bull market to recoup your losses and move you into the black? The academics may have it right in theory, but in the real world, DCA makes it easier for many investors to overcome their fears and make the difficult decision to put their savings at risk.

In summary, DCA is the systematic investing of a fixed amount of money on a regular basis, usually monthly. I especially like it when used in conjunction with no-load funds and 401(k) plans for these reasons:

• It eliminates the need to ask the question, "Is this a good time to buy stocks?" As far as DCA investors are concerned, every month is a good month.
• It imposes a savings discipline, forcing you to make regular "installment" payments on your future financial security.
• It will cause you to buy relatively more fund shares when prices are low and fewer shares when prices are high.
• Using no-load funds allows the purchase of fractional shares, eliminates commission costs, and provides sufficient diversification to reflect the stock market at large.
• By "automating" your program, you save time and eliminate the risk that you'll forget or be distracted by the market news of the day.

TRACKING YOUR PROGRESS

Let's walk through an example of some of the decisions involved in executing a DCA strategy. We'll assume that you've gone through Steps 2 and 3 of our 5 Easy Steps to Start Investing the SMI Way and determined that a "100% stocks" portfolio is appropriate for you given your current season of life and risk-taking temperament. You like the simplicity of our Just-the-Basics strategy, and have $5,000 available to launch your program. Creating your personal versions of the worksheets shown in the table below can help you deal with adjustments for fund minimums, dividends, annual rebalancing, and the occasional need to change the funds in your portfolio. They're intended to be read from far left to far right; it might be helpful to print them out to refer to as you follow along.

Of course, you don't need to maintain these kinds of worksheets in order to dollar-cost-average; I'm using them here to help illustrate several principles and retain a degree of precision. If they scare you off, just set them aside and settle for coming close. The important thing is to get started! Let's assume you began your program at a particularly bad time—in March 2000 at the height of the euphoria just before stocks experienced the worst decline since the Great Depression.

Step 1: Since Vanguard's minimum for opening a fund account is $3,000, you can purchase only one fund initially. The Total Stock Market Index fund is recommended for your situation  — at least until you reach the $6,000 level. This fund will give you exposure to both large and small company stocks. Important note: as your account grows in value, you will be able to add new funds that will gradually move your holdings toward a more conventional Just-the-Basics "100% stocks" profile—40% large company stocks, 40% small company stocks, and 20% international growth stocks.

Step 2: You expect to add $300 a month during the first year with the hope of increasing your monthly deposit by $50 every twelve months. Since you only own one fund at this point, the entire $300 for April is invested in Total Stock Market. To simplify matters, I assume your investment is made on the last trading day of the month. At a price of $29.39, your $300 buys another 10.21 shares.

Step 3: As you get ready for your end-of-the-month deposit in May, you check the value in your account and find it's fallen to $4,867. This isn't what you expected! In just two months, you've lost over $430, more than 8% of the $5,300 you've invested so far. But you know it's important to stay with your program regardless of what the market's doing, so you put in another $300. With shares down to $28.38, you get more for your money—another 10.57 shares are added to your account.

Step 4: Your June statement shows that your fund paid a dividend distribution that was reinvested in more shares per your earlier instructions. You post your new shares to your worksheet (column 3). If your Just-the-Basics strategy is not taking place in a tax-deferred account, you might prefer to not have the dividends reinvested in order to simplify the tax accounting paperwork.

Step 5: By the end of August, your account has rallied to $6,330. You've put in $6,200 (the original $5,000 plus four monthly deposits of $300 each), so you're now slightly above water. After what you've been through, it's encouraging to be in the black! You notice that with the $300 you're about to deposit, you'll have $6,630. It's time to graduate from Total Stock Market. You sell your shares.

Step 6: With the proceeds and your $300, you invest $3,315 in both the 500 Index and Extended Market Index funds. For the next several months, you'll split your monthly deposit and invest $150 into each of your two new funds.

Step 7: At the end of December 2000, your account is worth $6,322. Since the difference in value between the two funds is only a few hundred dollars, you might, for simplicity sake, dispense with the annual rebalancing effort. You make your monthly deposit as usual. Alternatively, if you're a stickler for precision, you have the option of depositing that month's entire $300 in the Extended Market fund to close the gap.

Step 8: After 12 months of making regular $300 deposits, you increase your monthly amount by $50 according to plan. This means you now invest $175 into each of your two fund positions.

Step 9: By the end of November 2001, your total account value is near $9,000. By using that month's deposit along with withdrawals from each of your two funds, you can raise the $3,000 needed to diversify even further. Since it's close to year-end, you'll make your computations so as to do your annual rebalancing between 500 Index and Extended Market Index; that is, after the transactions are done, the two funds will be roughly equal in account value.

Step 10: You open your International Growth account for the $3,000 minimum ($2,650 from selling shares in the other two funds plus your $350 monthly deposit). Your goal for this new fund is that it eventually represents 20% of your portfolio, not the 32% it does now. Because International Growth is overweighted in your portfolio, you do not add to it with any of your monthly deposits for the next year. Your $350 continues to be divided between the 500 Index and Expanded Market Index funds. (Depending on your enthusiasm for foreign holdings, you could have elected to wait and diversify later when the $3,000 minimum would have represented a smaller portion of your portfolio. For example, if you had waited until your holdings were worth $12,000, the new fund would have totaled just 25% of your portfolio; at $15,000, it would have been just 20%.)

Step 11: You raise your monthly deposit by $50 as planned. You now invest $400, divided between your two largest holdings for now (because the International Growth fund is still overweighted, i.e., represents more than 20% of your portfolio).

Step 12: It's January again, time to rebalance. You calculate the current value of your three funds ($11,949) plus your $400 monthly deposit. The total is $12,349. Following your target percentages (see step one), you determine the correct theoretical values for each fund. By selling off $227 of your International Growth shares, you reduce its value to 20% of your total portfolio. This money, along with your $400 deposit, is allocated to the other two funds so that they will each be worth 40% of the total.

Step 13: Starting in February, you divide your monthly deposit among all three funds according to their weight in the portfolio. This means putting 20%, or $80, in International Growth. The minimum deposit at Vanguard is usually $100, but it allows smaller monthly investments if you sign up for their "automatic investment plan." The investments are automatically made by a transfer from your checking or savings account.

Step 14: When you reach the three-year mark, things look bleak at first glance. Your total investments, which amount to $17,200, are worth just $12,364. The worst bear market since the Great Depression has taken its toll. (It's just ended, but you don't know that yet.) On the bright side, you've been scooping up shares at bargain prices the whole time. When the market finally rebounds, you'll be in great shape.

Step 15: What a difference a year makes! At the four-year mark, your bear market losses are a thing of the past. You have almost $2,000 in net gains, and the bull market is just getting started.

Step 16: After five years, your total deposits equal $28,500 (initial deposit of $5,000 plus monthly deposits of $23,500), but your account value is at $32,906. This represents a time-weighted return of 4.98% per year. During this same five-year period, the Wilshire 5000 Index has dropped 12.5%, but here you are in the black. Considering the magnitude of losses experienced by many investors, your confidence grows as you realize you've survived the worst market of the past 70 years and come out ahead.

The discussion thus far has centered around SMI's Just-the-Basics approach, a strategy where you use index funds in an attempt to stay even with the market. As you just saw, even with such a modest goal, DCA would have helped your Just-the-Basics portfolio outdistance the market, even during a really rough stretch. SMI's Upgrading strategy, where we use top-performing funds in an effort to consistently beat the market, would have done even better. The table on the left contrasts the hypothetical values at each annual anniversary of an Upgrading strategy (assuming similar starting amount, monthly deposits, etc.) with those from the Just-the-Basics example. Clearly, Upgrading gave a better result—11.06% annually vs. 4.98% for Just-the-Basics. The availability of the SMI Upgrading Funds now makes a DCA Upgrading program simple and convenient. (The Sound Mind Investing Fund and The SMI Managed Volatility Fund are separately managed entities from the SMI newsletter. Go to www.SMIFund.com for more information about these funds.)

Let's talk briefly about the timing of your monthly purchases. Many investors attempt to take advantage of monthly seasonality (see SMI Advanced Strategies ). This refers to the few days just before and after the first of the month. Studies have shown a tendency for the market—on average, over long periods of time—to be stronger on those days. I reran the numbers shown in the tables in this article, assuming you had invested on the third business day before the end of the month (as advocated by Norman Fosback, an early popularizer of monthly seasonality) rather than wait until month's end. To my surprise, it led to no meaningful improvement in the end results.

Upon reflection, I should have realized it wouldn't make much difference. The math is against you. If you're depositing $400 a month, even if seasonality gained you a 1% edge on each deposit, that would only be a $4 savings. Five years of this, even with compounding, amounts to an improvement of only a few hundred dollars.

I also gave some thought as to whether there was a way to profitably take advantage of the annual seasonality pattern. Since the market has been demonstrably weaker during the May-October period versus the more favorable November-April period, I wondered if it would boost results to make monthly investments only during those six months when prices were—theoretically—lower, thus getting more for my money. (The same total amount was invested annually; I simply doubled the monthly amount for the one six-month period and investing nothing during the other six months.)

It did manage to improve results in a DCA program, but only by a meager 0.1% per year. It's not that the market unfailingly falls during the unfavorable period (which would allow you to buy more shares with your money) which makes seasonality noteworthy; it's that it tends to stop going up. Of course, there's still an advantage to buying when stock prices have stalled (versus paying more as they're rising). But, just as with monthly seasonality, it doesn't have a large effect because the monthly amounts are small in relation to the total value of the account.

There are hundreds of variations on how DCA investments can be made. There's no single "right" way to do this, so don't second guess yourself or let small things (like getting your rebalancing precisely accurate) distract you from the big picture. The important thing is that you get started and stay with it. Being consistent in putting money into the market and keeping your transaction costs under control are more important factors than which day of the month you invest or maintaining your allocations precisely. Mechanical strategies like DCA are designed to make investing easier for you by removing your emotions from the equation. So don't stress out over the details. Relax, and enjoy the ride!

• Introducing the Sound Mind Investing Fund
• Introducing the SMI Managed Volatility Fund
• SMI's Model Portfolios page
• Getting Started Portfolios  
• Dollar-Cost-Averaging
• How to Virtually Eliminate the Risk of Capital Loss 

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