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Dollar Cost Averaging with a Brain

Bill Smith

Bill Smith

30 followers
I’m sure you’ve heard it before from your friendly investment advisor--dollar cost average (DCA) into mutual funds (buying more when the market is low, and buying less when the market is high); keep your money invested at all times in a strategic allocation between stocks and bonds (and other asset classes); and rebalance annually.


In the Intelligent Investor, Ben Graham defined investment and speculation as follows: "An investment operation is one which, upon thorough analysis, promises safety of principal and adequate return. Operations not meeting these requirements are speculative."


When it came to allocating holdings, he also advised using a tactical approach to the stock/bond mix ranging from 75% stocks/25% bonds to 25% stocks/75% bonds, as valuation conditions dictated. As the market gets expensive, lighten up on stocks and buy more bonds. As the market suffers a major decline, lighten up on bonds, and buy more stocks.


A DCA program on the surface sounds sensible and intelligent. But when you peel back the layers you soon realize there’s an element of speculation involved...which is continuing to buy when the market is expensive.


Why would an advisor recommend this? Valuations matter--the price you pay determines your returns. No company, and by extension no index, is a good investment at any price. Doing so will give you very disappointing results indeed—just ask Coke (KO) investors in the late 1990s who are just now breaking even. Yet your advisor would ask you to continue to invest at elevated levels. Wow, and to think people pay for that advice from “professionals.” I’m sure the answer why has more to do with their pocketbook and fees from Assets Under Management than your pocketbook and financial independence.


So how does a person intelligently invest in his work-place offered 401K, so as not to speculate and suffer dismal returns, when all that’s offered are index funds? How can you “DCA with a brain?” The answer: judge the valuation of a US Stock Market index, by using the Total Market Capitalization to Gross National Product (TMC/GNP) ratio and buy the market when it’s cheap, sell when it’s not. (Note: TMC/GNP is Warren Buffett’s favorite market valuation metric and is outlined here: http://www.gurufocus.com/stock-market-valuations.php )


A ratio of 0.75-0.9 is considered fairly valued with a growth curve of about 6% ann. Anything over 0.9 is overvalued, and anything under 0.75 is undervalued. At all times, you can determine the likely returns over a given time period, typically 8-10 years. As of this writing, the current expected return from the market over the next 8 years, at the current price level, is 3.9%.


Since asset classes compete for investment dollars, compare the market’s expected return (3.9%) to your alternative investment of comparable duration for preservation of capital—the 10 year T-bill, currently yielding 3.6%. For perspective, next compare it to the corporate bond index, currently yielding 5.8% and available here: http://www.bloomberg.com/markets/rates-bonds/corporate-bonds/


Now ask yourself, is there a sufficient margin of safety, and is this a sufficient return over the T-bill or bonds? If you answer yes, then buy the index. If you answer no, put your funds in short-term bonds/cash until such time as you get the required margin of safety and sufficient return. Do this periodically as new funds are added to your account. Please note, like value investing, this approach may involve some patience as markets can stay irrational for long periods.


Since I eat my own cooking, I apply these principals to my personal 401K using the table below, modified from Graham’s approach listed earlier:






TMC/GDP Ratio


Stocks


Bonds/Cash


> 1.15


0%


100%


0.90 – 1.15


25%


75%


0.75 – 0.90


50%


50%


0.50 – 0.75


75%


25%


< 0.50


100%


0%


Over time, this approach will force purchasing stocks when conditions warrant, and avoiding them when they’re expensive. It also has the advantage of preservation of capital by putting you into the bunker of bonds or cash when markets are overvalued.


When Mr. Market has his next manic-depressive mood swing, you’ll be ready and able to take advantage of the dirt cheap prices he offers with your slug of cash.


Happy index investing!


PS: I find it to be a telling matter of over-valuation when the expected return from the market is 33% less than corporate bonds, and just about on par with a T-bill.


Disclosure: my personal 401K is currently allocated as follows:




  • Extended Market Index (21%)
  • Aggregate Bond Index (49%)
  • Short-Term Gov’t Securities (30%)

About the author:

Bill Smith
I'm an IT professional and a private individual value investor with degrees in electronic engineering and business economics. My major investment influence is Warren Buffett--finding "wonderful companies trading at wonderful prices".

Rating: 4.3/5 (19 votes)

Comments

superguru
Superguru - 3 years ago
Why do you have so much in Aggregate Bond Index (49%)?

I thought treasuries are over valued and corps are fairly valued.

Bill Smith
Bill Smith premium member - 3 years ago
The allocation to agg. bonds is a result of slowly selling off an initial 75% stock position downward as the market advanced.

superguru
Superguru - 3 years ago
Bill Smith, I like your approach. It is better than periodic re-balancing as you take in account market valuations. I am a bottoms up value investor but in one of my 401k I am trying the passive approach.

I am still not understanding one thing about you moving from stocks to Aggregate Bond Index instead of cash( Short-Term Gov’t Securities).

If Aggregate Bond Index is overvalued, are you not moving from one overvalued asset class (stocks) to another overvalued asset (AGG). Should you not be moving more to Short-Term Gov’t Securities (30%) (which is practically cash.)?

You are moving up the capital structure with AGG so you need less margin of safety but you are taking on the interest rate risk and valuation risk for getting higher yields.

also, what do you use for Short-Term Gov’t Securities?
Bill Smith
Bill Smith premium member - 3 years ago
Superguru: thanks much. Like you, I'd prefer to pick individual stocks but we only have 5 index funds available, and they are all equivalents of: SPY,VTI, AGG, EFA, and SHV. I had this concept in mind for 2 years if I was ever forced into using indices. I started the 401K with a new job back in Oct, so I thought it was a good time to try it out. Naturally, it should underperform in the upper legs of a bull market, but should outperform during a bear market. I don't use the EFA-equivalent yet because I don't know the TMC/GDP valuation norms of the EAFE. So until I figure that out, it's the Extended Market Index.

I started the account at 75% Ext Mkt, and 25% Agg Bond--I picked the bond fund out of habit. When i added AGG I considered there may be interest rate risk in the process. But, I felt it'd be better to take a small hit to redeploy the money when the market dropped and the potential return increased significantly on stocks.

However, in January I started building the cash position when i remembered that I really didn't care for bond funds/ETFs--you don't really know what your yield is going to be (it's not like getting a real bond). Besides, they suffer losses too when everyone puts in redemptions during a panic--bond funds tanked in 2008-2009 also. I'll sell them off and replace with short-term bonds (cash).

During the market drop in March, the stock position fell to about 20% and I brought it up to 25% when the expected market return (5%) increased to 50% higher than the T-bill (3.2%). New money is contributed straight to cash and then I decide what to do.

On your last question, my short-term fund is linked to the 90-day T-bill.

Hope that clears some of it up. If not let me know.

gurulands
Gurulands premium member - 2 years ago


Hi Bill,

Where do I get the projected returns (8 year period) for the TMC/GDP ratio?

I would like to plug in a ratio and get the projected 8 year return. Do you know where I can get this info?

Best Regards,

Gurulands
Bill.Smith
Bill.Smith premium member - 2 years ago
Gurulands: the info you seek, methodology, and calculation, is available right here at Gurufocus, and it's updated daily at http://www.gurufocus.com/stock-market-valuations.php

They also have a Shiller P/E version here: http://www.gurufocus.com/shiller-PE.php

and a global markets version here, which I just started using: http://www.gurufocus.com/global-market-valuation.php

Also GMO 7-Year Forecasts are another good place to get data.

Cheers!

v/r

Bill

gurulands
Gurulands premium member - 2 years ago


Bill,

Thanks for your response, I appreciate you getting back to me.

Yes, I am familiar with the indicators here at GuruFocus and use them daily.

I am looking for the projection portion of all of this.

For example, when the market hit its peak back in late 2000 or early 2001 the ratio of TMC to GDP was 148.5. I would like to know the projected 8 year return at that point. I would like to know where I can look up the projected 8 year return for a ratio of 148.5.

Currently, the ratio of TMC to GDP is 95.7% and the projected 8 year return is 4.4%/year. Where does GuruFocus get this info from? GuruFocus provides a graph of TMC/GDP and I can scroll my cursor along the graph and it will display the ratio, which is great; however, I don't know what the projected 8 year return is for a given ratio.

Do you know where I can get the 8 year projection for a given TMC/GDP ratio?

Best Regards,

Gurulands
gurufocus
Gurufocus premium member - 2 years ago
Gurulands,

what you are looking for is the third chart at the right side of the market valuation page:

http://www.gurufocus.com/stock-market-valuations.php

The brown line is the chart is what you are looking for.

GuruFocus.

gurulands
Gurulands premium member - 2 years ago


GuruFocus,

Thanks for the input.

Where do you get this info from? Is it readily available? I would like to be able to look up a TCM/GDP ratio and see the projected 8 year return.

Best Regards,

Gurulands

gurufocus
Gurufocus premium member - 2 years ago
Please check the third chart on the right side of the Market Valuation page. The brown line there corresponding to the historical market returns assuming the TMC/GDP will reverse to 80% in 8 years. Please see the explanation in the page.

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