Today’s contribution comes from Scott Lowther our system tester/designer extraordinaire…..
I did something the other day that I have not done in a long time, I succumbed and read one of those main stream media articles on investing, and how dollar cost averaging pays off.
Since completing the Mentor program in 2007, I normally don’t go near these types of articles because I find that they are written from a limited awareness and often just rehashing the same old techniques, institutionalised into financial planning these days.
The premise of the article is that market timing is just too hard, so dollar cost averaging is one way to reduce the risk of getting timing wrong. To articulate the worst possible scenario for entering the market, the idea was to invest right at the peak of the market in 2007 then measure performance over the next two years.
In a nut shell, the article compared the approach of investing $25,000 on October 31st 2007 in the Vanguard Life strategy Growth fund (buy and hold), with a dollar cost averaging approach of investing $1,000 every month over the same timeframe, in the same fund.
The buy and hold strategy returned Negative 18.5%, while the dollar cost averaging returned Positive 0.5%. So on the surface the uniformed reader believes this is the way to go.
The problem is as we know, most people had some build up of savings invested prior to Oct 2007 and this is where the logic of the article starts to break down, because our original investment amount is still subject to the loss of 18.5%. The larger the initial investment the larger the pain and the more difficult it is to recover. For example take $75,000 (approximate average Superannuation holdings) invested at 31st October 2007 and then following the dollar cost averaging approach. At the end of two years your account is Negative 13.8% on $100,000 invested. ($75,000 initial plus $25,000 as dollar cost averaging)
Now let’s take a different approach, let’s assume we have completed the mentor program and understand about turning of our long trading system when the broad market tells us to. Now we will assume we have invested $25,000 in the same Vanguard Life strategy Growth fund, however in mid January 2008 when we get the signal to shut off our long system, we extract our funds and put it into a bank high interest account.
When we get our signal to re-enter the market in June 2009 we buy back into the same fund and measure performance as at Oct 31st 2009.
Now I used the actual unit purchase & withdrawal prices from the Vanguard website and an average value for bank interest derived from the NAB I-saver interest rates of 5.5%. (Interest rates stayed at the peak of 7.05 from Mar 08 to Aug 08.)
While conservative this approach nets a return of Positive 8.4% and works regardless of the amount initially invested.
I also took the liberty of running a back test (to ensure the same amounts and dates were used) on the long system I developed in the mentor program over the same time periods. I also used the bank interest instead of going short (this was to overcome the issue of the bans on short selling). This approach resulted in a Positive 18 % return over the same two year period.
Now you will notice that I did not attempt to capture either the high or the low of the market with my broad market switch.
So the Dollar Cost Averaging investing approach is not the panacea as described in the article as it exposes your portfolio to excessive and unnecessary risk. Not to mention the sinking feeling that you are throwing good money after bad.
However, on the other hand, just adopting the Trading Game Mentor program’s approach to broad market analysis and a conservative fund or cash scenario, you manage your risk and end up much further in front.
Happy trading.
Nice report Scott.