For investors who buy and hold, you’ve probably heard of “dollar cost averaging” already. A brief recap:
- Dollar Cost Averaging is a buy and hold strategy where the investor keeps buying a fixed $X worth of stock every pre-determined period (e.g. every month, quarter, or year).
- Dollar Cost Averaging aims to reduce the volatility of your portfolio. Investors who dollar cost average want to see the market fall. This allows them to buy more shares at a lower price so that when the market does eventually rebound, the investors will benefit even more from the rally.
There are two main flaws with dollar cost averaging (aside from the fact that buy and hold isn’t the best strategy).
#1 Dollar cost averaging only reduces the volatility of your portfolio if you existing portfolio is small.
Consider this scenario:
- Year 1: the S&P 500 is at 1500
- Year 2: the S&P 500 is at 750 (i.e. it fell 50%)
Investor 1 began Year 1 with $50,000. At the end of Year 2, his original $50,000 turned into $25,000, and he invested another $50,000 into the market. His total portfolio is now $75,000.
Investor 2 began Year 1 with $1,000,000. At the end of Year 2, his original $1,000,000 turned into $500,000, and he invested another $50,000 into the market. His total portfolio is now $550,000.
As you can see, dollar cost averaging clearly works better for Investor 1 – the investor with less money. Dollar cost averaging becomes less and less useful the bigger and bigger your portfolio becomes. Its ability to reduce your portfolio’s volatility shrinks over time unless your new savings grow inline with the size of your portfolio.
Dollar cost averaging is like a buffer. If you apply the same sized buffer to a bigger and bigger portfolio, it’s % impact becomes less and less.
#2 Dollar cost averaging doesn’t work well for investors who’s savings are cyclical
Buy and hold works for investors who can buy and hold. I.e. it works best for people with very stable incomes and very stable savings.
In the 21st century, this means that it doesn’t work for most people who aren’t teachers, government workers, doctors, etc.
Dollar cost averaging assumes that you can save and invest the same $X into the market, year after year regardless of whether the market goes up or down. Dollar cost averaging seeks to take advantage of markets that go down.
However, sometimes down markets coincide with recessions, which means that many investors CAN’T save and invest into the market at cheap prices.
Imagine a scenario in which you buy and hold and Dollar Cost Average. Every year, you try to save and invest an additional $50,000 into the market.
That strategy sounds great on paper. But along comes 2008, the economy is in a recession and you lose your job. You can’t afford to take advantage of cheap stock prices in 2008 because you have no job or additional savings.
This scenario is what many investors found themselves in 2008. Worse, many investors who didn’t have adequate savings and were unemployed were forced to firesale their stocks in order to put food on the table.
Why am I bringing this up
Perhaps you are one of these people who face the 2nd problem. I am bringing this up because soon I will manage the investments of a business owner in the construction industry.
Construction – like many other industries – is a very cyclical industry. When the economy is nearing the end of an economic expansion, he can earn $600k+ profits in a year. When the economy is in a recession, he’s lucky if his business doesn’t lose money.
I’m breaking his portfolio up into several strategies, one of which will be a small buy and hold component.
As a result of his business, his savings are also extremely cyclical.
- Towards the end of an economic expansion, when the economy is red hot, he takes home a lot of savings. If he invests all of those savings at the present market price, he won’t buy a lot of shares.
- In an economic recession, his savings are almost zero. He has no additional savings to take advantage of the bear market and buy more shares.
*By “shares”, I am referring to $SPY.
A better strategy to dollar cost averaging for cyclical savers/investors is what I call Pushed-Back Cyclical Investing
In essence, the investor pushes back all of his investing by 2 years (2 years because that is the average lenght of a major bear market).
Here’s an example.
- Year 2004: Construction Business Owner earns $200k. He invests this $200k into the S&P at the end of 2006
- Year 2005: Construction Business Owner earns $300k. He invests this $300k into the S&P at the end of 2007
- Year 2006 (economy is red hot): Construction Business Owner earns $700k. He invests this $700k into the S&P at the end of 2008.
- Year 2007 (economy is red hot): Construction Business Owner earns $800k. He invests this $800k into the S&P at the end of 2009.
- Year 2008 (economy is in a recession): Construction Business Owner earns $10k. He invests this $10k into the S&P at the end of 2010.
As you can see, this is clearly better than the following standard dollar cost averaging strategy.
- Year 2004: Construction Business Owner earns $200k. He invests this $200k into the S&P at the end of 2004
- Year 2005: Construction Business Owner earns $300k. He invests this $300k into the S&P at the end of 2005
- Year 2006 (economy is red hot): Construction Business Owner earns $700k. He invests this $700k into the S&P at the end of 2006
- Year 2007 (economy is red hot): Construction Business Owner earns $800k. He invests this $800k into the S&P at the end of 2007
- Year 2008 (economy is in a recession): Construction Business Owner earns $10k. He invests this $10k into the S&P at the end of 2008
With standard dollar cost averaging, the investor’s average share price is heavily inflated by his massive savings and investing in 2007. With my Pushed-Back Cyclical Investing strategy, the investor’s average share price is heavily weighed down by depressed stock prices in 2008 and 2009, which is good for the investor.
In the following chart we compare 3 people. Each person saves an average of $50k per year and starts with a portfolio of $50k in cash. The starting year is 1998 (late in the economic expansion cycle).
- Steady Saving & Investing: this person has a very stable job and saves the same $50k every single year (inflation-adjusted). He invests it into the S&P at the end of each year.
- Cyclical Investing: this person is like the construction business owner. His business is very cyclical, which means that his business profits and savings fluctuate with the business cycle. He invests his savings (average of $50k, but with wild fluctuations) into the S&P at the end of each year.
- Pushed Back Cyclical Investing: this person is the same construction business owner. But instead of investing each year’s savings at the end of the year, he waits 2 years until he invests.
- The “Steady Saving & Investing” person has the best overall performance. This demonstrates that if your investment strategy is to dollar cost average and buy and hold, it’s best if you have a very stable job. Otherwise all sorts of economic risks mess with your ability to dollar cost average.
- For the cyclical investor, it’s better to delay investments by 2 years. The overall return in 2018 is approximately the same. However, the returns are much more stable. In a bear market, the investor doesn’t suffer as heavy losses as the cyclical investor who puts all of his 2007 earnings into the stock market’s top in 2007.
Now you can say “this figure is skewed because it begins in 1998”. In a way, yes it is skewed. This strategy works best when buy and hold investors start to use it toward the end of an economic expansion and bull market. But we are near the end of this economic expansion right now, which makes this all the more useful.
What if we started using this strategy very early in a bull market? Afterall, this strategy’s benefit occurs during a bear market.
As you can see, there isn’t much harm done, and the final return for Pushed Back Cyclical Investing is marginally higher than buy and hold.