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Dollar-Cost Averaging with a Brain: One Year Later
Posted by: Bill Smith (IP Logged)
Date: February 10, 2012 03:26PM
A year ago I wrote "Dollar Cost Averaging with a Brain," which started as an idea to enhance a typical dollar-cost averaging program. I thought it was time to revisit it and apprise the GuruFocus community of its performance. I'm pleased to report that after its first year, as of the trailing 12 months ending Jan. 31, 2012, it achieved 13.64%, compared to the S&P's total return of 2.5%.
Why Did I Decide to Do This?
Necessity, as they say, is the mother of invention. I had a problem to solve. In October 2010, I had a new employer-sponsored 401K which only offered indices. Since I enjoy picking individual companies and didn't have that option available in this account, I wanted to be able to apply value-investing principles to managing it.
Some might ask why I just didn't follow the standard financial planner mantra of: stay continually invested in a strategic allocation, purchase at periodic intervals, and rebalance annually.
For a number of reasons, actually.
What Does It Do?
Quite simply, it's a valuation-informed method of indexing, adapted from Ben Graham's teachings. It seeks to purchase a stock index when it makes valuation sense to do so, and to refrain purchasing when it's overpriced. Additionally, depending on the severity of over- or under-valuation, it adjusts the allocation appropriately to either preserve capital, or to take advantage of depressed markets.
How Does It Do It?
It uses the TMC/GDP ratio, (Warren Buffett's favorite ratio, to judge market valuations) as a guide post, by assessing likely returns going forward from current prices. This information is used and compared to other expected returns/yields from other indices to make decisions. Procedurally, it follows the basic value investing process: Buy when cheap, and sell when fairly- or over-valued; then repeat.
The 2011 Play-by-Play
Here's a quick rundown of the pivot points during the year.
As of this writing, the total stock weighting is still 50% (30% international, 20% extended market index). Expected U.S. market returns are 4.5%, compared to the corporate bond index with an average redemption yield of 4.3%.
Art & Science
The science of this approach, assessing future expected returns, is the easy part.
The hard part, the art, is dealing with the mechanics of your individual 401K. For example, in mine, money flows in every two weeks; only two inter-fund transfers are allowed each month; and fund transactions are done at the end of the day. These mechanics pose some limitations, especially when a significant drop occurs and you want to take advantage of it. If you've already used your monthly inter-fund transfers, you either have to wait until the next addition of capital (which might not be large enough for what you're trying to do), or wait until the following month (and hope prices stay depressed). It's not impossible, but dealing with these nuances does present a minor challenge to take into account.
I do have some tweaks planned to optimize this approach and will discuss those in subsequent articles.
Over time, this approach should force purchasing stocks when conditions warrant, and avoiding them when they're expensive. It should naturally under-perform during bull markets, since it won't be fully invested in stocks. However, it should out-perform during bear markets as you deploy the cash built during a rising market.
It's only been a year, but judging by it's initial performance I'm cautiously optimistic this approach will work better for me than a mindless, mechanical dollar-cost averaging program. I believe I'll be able to hit my long-term goal for this account of 9% annually.
If nothing else and I don't hit my target, I will have at least had fun in the process knowing that I applied my favorite discipline, value investing, to the purchase of indices.
And that's what matters to me...
DISCLAIMER: This analysis is provided for informational and entertainment purposes only and is the opinion of the author. The information and content contained herein should not be construed as a recommendation to invest or trade in any type of security. Neither the information, nor any opinion expressed, constitutes a solicitation of the purchase or sale of any security or investment of any kind. Conduct your own research and due diligence.
Stocks Discussed: SPY, EFA,