Wednesday, March 24, 2010

Dollar Cost Averaging: An In Depth Investigation Using EEM

Money is burning a hole in my pocket. With my brand new Roth account and newly transferred funds I am itchy to spend it. I already decided on which fund I need to buy to reach my target portfolio goals, so why haven't I purchased the iShares Emerging Markets ETF yet? I am waiting for the perfect time to invest, of course!

Streetsmart Guide to Timing the Stock Market: When to Buy, Sell, and Sell Short (Streetsmart Guides)I recently quoted an article by Morningstar that raised a flag of caution for investors to not succumb to the temptation of using commission free ETF trades to begin market timing. Market timing is highly debated and is very alluring. In fact, MarketWatch just released an article on several different strategies for taking advantage the seasonal trends in the marketplace. Essentially, they were outlining well used market timing strategies. 

Once upon a time, when I was a greedy investor, wait, I still am! Okay, once upon a time when I was a novice investor, I would have been thrilled to read about seasonal trends in the marketplace. If the market experienced regular trends that were seasonal then that meant there was an opportunity for me to take advantage of that trend and increase my yearly yield. Timing is everything. We all know that. If we had just known to invest all of our money last March when the market bottomed and made its turn around. Or if we had just known to pull our money out before the market fell off the abyss in 2007-2008. Yes, hindsight is always 20/20. IF we had known. Trouble is, we live in the present and we do not know what the future will bring.

Value Averaging: The Safe and Easy Strategy for Higher Investment Returns (Wiley Investment Classics)I now know that dollar cost averaging is the right answer. I have read about it and seen the research. But to convince myself, I wanted to run the numbers myself. Since, I am going to be investing in EEM, it will be the point of this study. I went back and recorded, roughly, what the price of EEM has been for the last three years during the mid point of each month into a spreadsheet. Then I created several different investing scenarios to illustrate lump sum investing, or market timing, and regular, automatic investing known as dollar cost averaging or Value Averaging. 

Since this is a Roth account, my year to year analysis is from March to February of the next year because a lot of people make their Roth contributions right before the April 15th deadline for prior year contributions. And because the last three years provided me with the perfect worst year, best year, and good year data to explore the different options and scenarios. The results are very interesting. Granted, EEM is a very new fund without even a full 10 year history.

Let's start out with one really bad year. From March 2008 to February 2009 time frame was a bad year. In fact, EEM saw a 54% decline. Ouch! So, what would your fund value be in Feb 2009 if you invested $5k in March 2008, versus a steady $416.67 per month?
DollarCostFund = $3,530.15
LumpSumFund =  $2,650.38

In contrast, let's examine a great year. From March 2009 to February 2010 time frame was an awesome year. In fact, EEM experienced nearly 80% growth. Wow! So, what would your fund value be in Feb 2010 if you invested $5k in March 2009, versus a steady $416.67 per month?
DollarCostFund = $6,032.37
LumpSumFund =  $11,298.81

Yeah, but what about longer term. If you had the stomach to sit through those past two years and just kept to your guns from March 2007 to February 2010 time frame EEM only grew by 3%. So, what would your fund value be in Feb 2010 if you invested $5k in March every year, versus a steady $416.67 per month?
DollarCostFund = $16,911.20
LumpSumFund =  $21,616.31

Should I be worried that the lump sum investing performed 28% better than dollar cost averaging? No, not really, because the yearly lump sum, if done regularly, is also dollar cost averaging. I generated the last plot to better illustrate the point of a person actively deciding which month to invest. I picked the best months during each March to February year and the worst months to invest. The average person probably wouldn't pick the worst times, but they also are not likely to pick the best times either. So, what would your fund value be in Feb 2010 if you invested $5k at the best times, and the worst times, versus a steady $416.67 per month?
DollarCostFund = $16,911.20
BestLumpSumFund =  $26,027.71
WorstLumpSumFund = $12,644.39

 In conclusion, dollar cost averaging never produced the best results, but it did reduce risk, and performed better in a bear market. Additionally, dollar cost averaging has the added benefit of being automatic. One of the great things about using automatic systems is that you can set them and forget them. Imagine if you were simply too busy and just left your cash contributions rotting in a money market fund last year!

 Which path will I take? I have contributed the max amount, $5k, for my 2009 year contribution to my Roth IRA. Will I try and time the market based on my gut feel, the current price, the current news stories? Or will I just take the long and boring road to average wealth? Yeah, time to figure out how to set up automatic investing inside of Fidelity.

How about you? Does this analysis make you reconsider your stance? Does it reinforce your current behavior?

You may also be interested in reading:
You Can Lose Money Selling Your Investments
Selling Your Investments Means You Get to Buy New Ones
ETF's and Lazy Portfolios
Dollar Cost Averaging: An In Depth Investigation Using EEM
Alternatives to My Investing Decisions

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