Dollar Cost Averaging: The Right Way
I was born in 1981 and my first year of college was 1999. What if my parents would have decided to invest 25 $/month from the time I was born to the time I started university? For sure they would have experienced the dot-com bubble. The Dollar Cost Averaging (DCA) approach would not have survived well: the market dropped by ca.50%, the recovery took ca. 7 years and exactly the same would have happened to my saving account; see light green line in the first image below.
Why did it happen? Sure, the market has its cycles but basically there are a few things that could have been done to mitigate what happened during the dot-com bubble and the house market bubble crises.
First: the amount of money that is injected in every DCA should constantly increase over time. Let’s say our parents are generous and they get a few promotions over the years, we can then assume that they would increase the amount of money they donate by 7.5% per year. By doing so, they would have managed to reduce the drawdown duration by 1.5 years (5.5. years in total) while, unfortunately, the drawdown would have stayed at ca. 50%; see dark blue line in the first image below.
The second thing that they could have done, it would have been not to put all the eggs in the same basket and diversify the asset allocation. In this example I have chosen 60% equities (S&P500) and 40% medium term T-bonds. Surprise, surprise, they would have now been able to experience 22.5% max drawdown during the dot-com bubble for a duration of 3 years. Much better right? Moving forward in time and we get the house market bubble. This time we get a steeper drawdown (35%) while a recovery time of 1.4 years. In comparison, it took ca.5 years to the S&P500 to get back to the previous high.
What did we learn so far? DCA is not a magic bullet to navigate through difficult times. The market goes through cycles and when they happen, it is better to be prepared. Preparation means: implement DCA, diversify your assets and steadily increase the amount of money you place each month in the brokerage account. Lastly and most importantly make a few calculations to verify that your plan is solid. Yes, the S&P500 returns an annualized 10% but do not forget that there are market cycles. These cycles might take several years to recover and we definitely do not want to lose capital when we need it the most.
If we now want to improve our drawdown even more, there are ways to do that. Somewhat complex and counterintuitive but worth. What are these tricks? First the split between equities and bonds can be adjusted over time. When we are infants we do not need money so our parents can invest in riskier assets e.g. 100 equities. As we grow up, we slowly start investing more and more in bonds. In this new example 40% after 40 years. To further improve the performances of the account, it is beneficial to add more money when the market goes down and less when it goes up. By doing that our return on investment is very similar to the 60-40 case but this time, the maximum drawdown is 24% while its duration 1.2 years. See dark blue line below. Better, is not it?
I am very tempted to talk about NEXT-alpha and make a case study around it but today I’ll skip it. It does not sound fair for the equity market. But it is important to keep in mind that there might be better strategies out there other than the traditional equities-bond allocation.
This article was written after opening a brokerage account for my 3 years old toddler and make him benefit of everything I have learned in the last decade.